The bearish reading goes as follows. The upward trend since the mid-00s shows that a favourable supply shock - the flood of cheap imports from the far east - has been fading away. Also, this could be a sign that the output gap is not as great as the 6 per cent-plus which the Treasury estimates. Its idea that our potential growth rate is 2.75 per cent a year was always optimistic, and the credit crunch has made it even more so. This matters. If there's less effective spare capacity in the economy than thought, the recovery could lead to inflation rising surprisingly quickly.
There is, though, an alternative view, which says that core inflation might head down:
1. The fact that core inflation is as high now was it was before the VAT cut shows that retailers have used that cut to gradually edge up their margins. If so, the restoration of VAT to 17.5 per cent might cause these margins to be squeezed. Yes, they might try to pass on some or all of the increase, with the result that inflation rises early next year. But with households' incomes squeezed by rising prices, minuscule wage increases and rising unemployment, such rises might merely drive away customers, so they won't stick. If so, the path of core inflation next year could be a mirror image of this year - an early increase, followed by a drift down.
2. Inflation is still being boosted by last autumn's fall in sterling, which raised import prices and hence - with a lag - consumer prices. This effect should gradually fade away.
3. You wouldn't expect the recession to reduce inflation quickly. In a recession, productivity falls which causes unit costs to rise. Firms desperate to maintain cashflow respond to this by trying to raise prices. And there's no point cutting prices in a recession if there are few customers around to be won. Instead, inflation typically falls early in an upturn, because its then that productivity soars and unit costs fall, and then that firms cut prices to win more customers. So, we should see core inflation fall as the economy recovers next year.
The Bank of England, and most private forecasters, take this latter view. The Bank expects CPI inflation to fall back to 1.6 per cent by Q4 next year, whilst private forecasters envisage it dropping to 1.7 per cent. For what it's worth - which is nothing - I'm inclined to agree.
