Today’s inflation figures appear to show what many have been hoping for – inflation in the UK may now have peaked. On the Bank of England’s target measure, the Consumer Prices Index (CPI), inflation edged down to 5.0%Y/Y in October, from 5.2% in September. For the millions of people still feeling the pinch, that pace of disinflation is hardly going to have a big impact, particularly with recent electricity and gas price hikes still being digested. But it does raise the prospect of September being the peak in inflation, and of the cost of living decelerating over coming months. So an obvious question is how quickly inflation will fall back.

Based on the difference between September and October (0.2 percentage points), it would take another 15 months for inflation to fall back to the BoE’s 2% target – we would get there for the start of 2013. But inflation rarely unfolds in such a regimented way. In practice, the current twelve-month change in the CPI reflects a whole series of current and past changes in prices, from petrol through haircuts to computer games. Some prices in the economy change far more frequently than others, while the amount by which prices change also varies considerably. As such, while it is very hard to know exactly how much petrol will push down on inflation over the next year, because petrol prices change a lot, it is easier to gauge the impact of other factors.

One of these is taxes. Throughout 2011, a large chunk of the inflation that we have seen has been imposed by the Chancellor, George Osborne. Headline CPI inflation has averaged 4.5% from January 2011 to October (today’s figures). But if tax rates had been held constant – most obviously VAT, but also other duties and charges – then average CPI inflation would only have been 2.8%, according to the ONS. In other words, over a third of the inflation that we have seen this year reflects Osborne’s plan to trim the deficit by increasing tax revenues (while also cutting government spending somewhat more sharply).

George Osborne

George Osborne-By Gary Barker (garybarker.co.uk)

Unless Osborne pushes through similar tax hikes next year, this means inflation will fall back in 2012. Without another hike in VAT to 22.5% on 1 January next year, the past VAT rise will drop out of the twelve-month window and inflation will drop too. (It’s not quite as simple as this, of course, as the pass-through of the VAT rise was partial and staggered.) Similarly, with Conservative backbenchers putting pressure on the Chancellor not to increase fuel duty by 3p in January, other tax effects could also be important.

But, aside from taxes, getting the rest of the inflation basket right is tricky. We have only just seen gas and electricity prices jump in September, so the inflation rate for these fuels (not including petrol) is currently running at around 20%, and will only decline gradually over the next twelve months. As with taxes, when we get to September 2012 there should be another step down in inflation, unless suppliers force through further hikes. But, in the meantime, it is possible that other prices may move up or down to distort the decline in CPI inflation that we should see during next year.

Perhaps the bigger point is that inflation should definitely fall back. Absent the third of inflation that is tax, and a contribution of around 1.5% from petrol, electricity and gas prices, underlying inflation is actually pretty contained. That is also borne out by the labour market – there is simply no sign of private sector wage inflation spiking higher, which is really the only way CPI inflation could get stuck at 5% for several years in a row. But weak wage growth in the labour market also means that the debts households currently bear will not be eroded quickly. And although consumers will see less squeeze on their spending power from inflation next year, the past squeeze from this year will not unwind. With the economy still rebalancing at a snail’s pace, that means that the chance of a double-dip is very real (even without Europe). Now more than ever, we really do need to see a genuine plan for growth from the Chancellor.

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