Inflation has risen by more than expected. Today’s figures show that the consumer price index rose by 5.2 per cent in the year to September, exceeding economists’ forecasts of 4.9 per cent. This is a rise of 0.7 percentage points from August’s 4.5 per cent rate. Of this rise, 0.47 percentage points were due to higher utility bill inflation, with other contributions coming from food prices, air fares and phone charges.

So, do we have an inflation problem?

No. These figures tell us that we have had an inflation problem. It’s highly likely that inflation will fall a lot next year. Basic maths tells us as much. For example:

- Food prices rose six 6 per cent in the year to September. However, food commodity prices have recently plunged, and this should eventually moderate price rises. If food inflation drops to two percent, inflation will fall by 0.41 percentage points.

- It’s unlikely that utility bills will rise as much next year as they have this. If utility inflation falls from 18.3 per cent to, say, five per cent, another 0.59 percentage points will come off inflation.

- Petrol price inflation was 17.8 per cent in the year to September. But this is largely due to rises in the spring, when Brent crude rose above $120pb. With crude now under $106pb, petrol prices have actually fallen since May. If petrol inflation drops to zero, 0.77 percentage points will come off CPI inflation.

- VAT will not rise next January as it did last. This means around 1.2 percentage points will come out of inflation in the new year.

If we add all this together, we get a drop in inflation of three percentage points by late 2012. This would take CPI inflation to 2.2 per cent.

Maths, then, points to inflation falling. But what of the behavioural effects on inflation?

There are two reasons to expect a rise.

One is that memories of current above-target inflation might lead people to expect prices to rise in the future. And such expectations can be self-fulfilling. The Bank of England’s recent survey showed that the public’s expectations for inflation have risen recently.

Another is that, insofar as it does stimulate the economy, quantitative easing might lead to some price rises.

On the other hand, though, high and rising unemployment should hold down wage inflation and hence the growth in company costs, and the squeeze on real incomes caused by vestigial inflation in the next few months might encourage retailers to hold prices down.

Most economists think the net effect of forces such as these will be small, and that inflation will therefore fall sharply because of the maths. The consensus forecast is for CPI inflation to fall to 2.2 per cent in the fourth quarter of next year.

This matters for investors. If the consensus is roughly right it means that the better cash savings accounts are now paying a positive real interest rate, unless you’re a top-rate taxpayer. Cash, then, doesn’t look as unattractive as it has been.

In this sense, basing your investment decisions upon today’s inflation rate is rather like driving by looking only in the rear-view mirror. It’s not to be advised.


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