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Mervyn King, the governor of the Bank of England, warned yesterday that Britain would flirt with deflation next year as a weakening economy, lower commodity prices and the cut in VAT combined to limit price increases.
Writing to Alistair Darling to explain why the Bank's monetary policy committee had allowed inflation to rise more than a percentage point above the chancellor's 2% target, King said he expected the cost of living to continue its rapid decline.
"It is likely that overall CPI [consumer price index] inflation will return to target in the first half of 2009 and then move materially below it later in the year," the governor wrote. "It is possible that I will not need to write a further open letter to you in three months' time. Indeed, given the short-term outlook for inflation, it is quite possible that I will next need to write to you to explain why inflation has deviated by more than one percentage point below the target during 2009."
King also hinted that extra help might be needed to get banks lending again. He wrote: "Additional measures, building on the government's package to support the banking system announced in October, will probably be required to underpin lending to households and companies."
His letter came after official data showed that inflation as measured by the CPI slowed to 4.1% in November from 4.5% the previous month. That was the lowest rate since June, but more than double the Bank of England's 2% target and not as big a fall as economists had expected.
Petrol prices tumbled 8% in a single month to their lowest in nearly two years. The AA said the average price of unleaded was now 89.5 pence a litre - 25% lower than the summer's record high of about £1.20. Diesel is now £1.02 on average, compared with a peak above £1.33. But the Office for National Statistics said the fall in petrol prices was partly offset by rising fruit prices, driven up partly by the fall in the pound's value as much fruit is imported.
The retail prices index (RPI) yardstick of the cost of living, which includes a measure of house prices and upon which most pay deals are set, fell to 3% - the lowest since May 2006 - from 4.2% in October. Economists believe that this measure of the cost of living will turn negative in the new year and may show up falls of 3% or more by the middle of 2009.
The Bank expects inflation to slow sharply in coming months thanks to a combination of falling fuel costs, economic slowdown and the cut in VAT. King noted that since the summer, when crude oil prices peaked at $147 a barrel, they have fallen by two-thirds to about $45, while food prices have dropped by nearly 40%.
Amid anecdotal evidence that retailers were forced into early winter sales to attract shoppers before Christmas, the City had been braced for CPI to dip below 4% last month. Analysts said, however, that further falls in the cost of living could be expected in the new year and there was no bar to the Bank continuing to cut borrowing costs. The bank rate has dropped from 5% to 2% since October.
Hetal Mehta, senior economic adviser to the Ernst & Young Item Club, said: "Next month's inflation data should show a much steeper drop, particularly on the RPI measure as the VAT reduction and larger interest rate cuts feed through. Item believes that by next year, RPI inflation will be in negative territory and the CPI measure will almost certainly undershoot the 1% threshold. With this in mind, the Bank of England is likely to cut interest rates even further." Philip Shaw, of Investec, said: "The UK is still in the early stages of what is going to be a steep decline in inflation that will see the CPI and RPI in negative territory for much of 2009."
Vince Cable, the Liberal Democrat Treasury spokesman, said: "There is an air of unreality about these numbers, since most analysts and businesses are seeing evidence of falling prices. This is likely to be the way the world will be for the next couple of years. But these figures do suggest that at a time when we're heading into a painful recession, many people are still seeing their living standards falling."
- Bank of England
- Inflation
- Liberal Democrats
- Economic policy
- Energy bills
- Household bills
- Family finances
- Consumer affairs
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