Households feel the pinch

Consumer price inflation was 4.0 per cent in March, according to the latest figures released this morning by the Office for National Statistics.

Consumer price inflation was 4.0 per cent in March, according to the latest figures released this morning by the Office for National Statistics.

Although the fall in inflation from 4.4 per cent in February was unexpected, inflation remains well above its target rate of 2 per cent and there is little prospect that it will return to its target rate in the rest of 2011. Higher food and fuel prices and January’s increase in the standard rate of VAT are the main factors behind the overshooting of the inflation target.

Despite the prospect of inflation exceeding its target rate for the rest of the year, the Monetary Policy Committee (MPC) left interest rates at their historically low level of 0.5 per cent when it met earlier this month. A minority grouping on the committee has been arguing for several months that interest rates should rise but it has yet to persuade its colleagues that action is needed to counter inflation pressures.

The principal argument presented against higher interest rates is the fact that most of the inflation pressures faced by the UK today are external – resulting from higher global commodity prices, one-off – the increase in VAT, or transitory – reflecting higher import prices as a result of sterling’s depreciation.

Since the MPC cannot influence the first two of these factors, and has only limited influence on the third, the suggestion is that higher interest rates would be pointless.

To an extent this is true, though those in favour of higher interest rates can reasonably point out that most of the fluctuations in inflation pressures in the UK, since the MPC was established in 1997, have been external in their nature and that the MPC was less reluctant to cut interest rates, or hold them at a low level, when inflation was below 2 per cent as a result of cheaper imported manufactured goods.

A better argument against higher interest rates is the gloomy outlook for economic growth. The OBR and the OECD have recently revised down their forecasts for growth in the UK in 2011, and the IMF are likely to follow suit later this week.

The main cause of these downgrades is a reassessment of the outlook for consumer spending. With average earnings increasing at little more than 2 per cent and price inflation at 4 per cent (or more than 5 per cent on the retail price measure), households are being forced to cut their spending in real terms.

This has been evident over the last few weeks as a stream of high street businesses have released disappointing trading statements. And it has now been confirmed by the results of the latest survey from the British Retail Consortium, which shows total sales in March were down 1.9 per cent on a year earlier. Even allowing for the distortion caused by Easter falling in March in 2010 and in April this year, this is a shocking figure – the largest annual decline since records began in 1996.

Retailers hope that April will bring some relief, with the long Easter weekend followed shortly by the royal wedding. But April also saw national insurance contributions increase for many workers and the public spending cuts will soon start to have a significant impact.

It is unlikely that things will get much better on the high street for several months and this – rather than the origins of the UK’s inflation pressures – is the real reason why interest rates should not be increased.

Also released today were the latest trade figures, which showed the deficit on trade in goods and services narrowed to £2.4 billion in February, from £3.9bn in January. The good news is that export growth remains strong; the bad news is that imports fell sharply – another sign of the poor outlook for domestic spending.

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