Record Rise in Consumer Price Index Due to VAT, Other 'Exceptional Events'

25 January 2010, 15:04

The Office for National Statistics (ONS) recently announced a record jump in the Consumer Price Index (CPI) last month. The CPI rose 0.6% last month; the annual rate jumped from November’s 1.9% to 2.9%, the largest increase since they began keeping the record in 1997. The ONS attributed the jump to a “number of exceptional events that took place in December 2008.” The sharp increase raises worries about inflation and could signal a rise in interest rates, sooner than had been thought.

Value Added Tax and Other Exceptional Events

The CPI reflects the change in prices from one year earlier. The ONS explained the record increase by noting the unusual circumstances of December 2008, such as the change in Value Added Tax (VAT). At that time, the standard rate of VAT – 17.5% – decreased to 15%. Other events included the sudden drop in oil prices and the economic malaise causing retailers to offer discounts. Between November and December 2008, the CPI fell 0.4%, a record decrease. An increase in December 2009 was expected.

Surprised Markets

Economists had expected CPI to rise, but not this much. They forecast a monthly increase of 0.2% and an annual increase of 2.6%. Real figures exceeded both. Markets responded by pricing in a rise in interest rates earlier than had been expected. Those rates have been held at the historically low 0.5% since March 2009.

Rising Interest Rates

A rise in interest rates will make it more difficult for consumers to borrow; even a modest rise may cause mortgage repayments to increase significantly. It also means that people taxed at the basic rate need a savings account that pays at least 3.63% in order to gain any real benefit from their savings. The real return on an average no notice savings account after basic tax and inflation is minus 2.3%. Financial experts note that the situation is especially unjust to prudent savers who are now faced with historically low savings rates and spiralling inflation.

VAT Change Continues to Affect Rates

VAT was reinstated at 17.5% on 1 January 2010. Economists believe that the reinstatement of VAT will cause CPI to rise above 3%, which triggers a letter of explanation from the Governor of the Bank of England to the Chancellor. The letter will explain why inflation has exceeded the 2% target rate by more than a percentage point. Ideally, it would indicate a declining CPI to come, but with even core inflation rising sharply, the future remains uncertain.