Inflation is coming down more quickly than the Bank of England expected as the impact of the post-EU referendum fall in the value of sterling washes out of the system.
That was the good news from official data showing that the government’s preferred measure of the annual increase in the cost of living dropped from 3% in January to 2.7% in February.
The bad news for homeowners worried about having to pay more to service their mortgages is that the easing of inflationary pressure may not influence the Bank’s monetary policy committee’s decision all that much. The Bank still wants to raise rates and could do so as soon as May.
Threadneedle Street always thought the Brexit-influenced spike in inflation was likely to prove temporary. Sterling fell on the foreign exchanges after the Brexit vote in June 2016 and over the next year dearer imports led to the CPI measure of inflation rising from 0.5% to 2.6%. In the second half of 2017, inflation briefly topped 3%.
But the annual inflation rate assesses what has been happening to prices over the latest 12-month period and as a new month comes in an old month drops out. The months that are now dropping out – in early 2017 – were when the effects of a weaker pound were most marked.
Of more concern to the Bank is the state of the labour market. It believes an unemployment rate of 4.4% – only marginally above its lowest since the mid-1970s – is starting to put upward pressure on wages.
What is inflation and why does it matter?
Inflation is when prices rise. Deflation is the opposite – price decreases over time – but inflation is far more common.
If inflation is 10%, then a £50 pair of shoes will cost £55 in a year’s time and £60.50 a year after that.
Inflation eats away at the value of wages and savings – if you earn 10% on your savings but inflation is 10%, the real rate of interest on your pot is actually 0%.
A relatively new phenomenon, inflation has become a real worry for governments since the 1960s.
As a rule of thumb, times of high inflation are good for borrowers and bad for investors.
Mortgages are a good example of how borrowing can be advantageous – annual inflation of 10% over seven years halves the real value of a mortgage.
On the other hand, pensioners, who depend on a fixed income, watch the value of their assets erode.
The government’s preferred measure of inflation, and the one the Bank of England takes into account when setting interest rates, is the consumer price index (CPI).
The retail prices index (RPI) is often used in wage negotiations.
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Earnings growth has been creeping up and before too long earnings will be increasing more quickly than prices. The sharper than expected fall in inflation means the return to rising real incomes will occur sooner and that will mean stronger growth and – from the MPC’s perspective – the threat of higher wage inflation.
While there has been little in recent economic data to justify a May increase in rates, earnings data will be crucial. If the annual increase edges closer to 3%, a spring rise will be a real possibility.