Inflation is on course to plunge below one per cent next year as the UK economy slides into recession, Bank of England Governor Mervyn King signalled.
In a letter to the Chancellor to explain why inflation had risen so far above its two per cent target, Mr King also revealed there could be more help to get banks lending again to households and businesses.
The latest dialogue with the Treasury was penned after official figures revealed the annual rate of UK inflation stood at 4.1 per cent in November, down from 4.5 per cent in October, but still above the 3.1 per cent level that triggers a quarterly letter of explanation from the Governor.
Mr King first wrote to Alistair Darling in June to explain why inflation was more than one per cent above the Government’s two per cent target.
But while inflation remains more than double the target, the Consumer Prices Index (CPI) has been falling fast since October as a looming recession has brought oil prices tumbling down and reined in firms’ pricing power.
Mr King said it was “quite possible” that his next letter to the Chancellor would be to explain why inflation had fallen more than one point below the Bank’s two per cent goal.
The Governor’s hints of measures to free-up the UK lending drought will spark speculation over a potential package of so-called “quantitative easing” – pumping more money into the economy in a bid to spur on lending.
The Treasury announced it would lower the cost of fees for banks using its £250 billion credit guarantee scheme under plans to jump start the lending market.
It is thought that as well as quantitative easing, the Government may be looking at introducing guarantees for interbank lending to kick-start wholesale money markets.
Mr Darling said in a reply to Mr King’s letter that he would keep measures to support lending “under review”.
The fall in the CPI official measure of inflation saw inflation fall to its lowest level since June, although it was higher than the 3.9 per cent expected by most economists.
The figures from the Office for National Statistics (ONS) showed that tumbling fuel inflation – which saw its largest decline since records began in 1997 – helped bring CPI down for the second month in a row.
The easing in oil prices saw the average price of petrol in the UK fall by 9.3p a litre between October and November, to 95.2p a litre.
However, the ONS data also showed that food inflation continued to put upward pressure on CPI last month, with fresh fruit and vegetables more expensive than a year ago.
Mobile phone charges were also higher than in November last year, added the ONS.
Meanwhile, hefty drops in house prices and the Bank of England’s dramatic 1.5 per cent cut in interest rates last month helped bring Retail Prices Index (RPI) inflation down to its lowest level since April 2006.
RPI, which includes mortgage interest payments, dropped to three per cent in November from 4.2 per cent the previous month -– the fastest decline for more than 17 years.
The impending UK recession and the Government’s reduction in VAT to 15 per cent from 17.5 per cent earlier this month is set to bring both CPI and RPI inflation down even further. The ONS estimates that if the VAT cut was passed on in full, it would wipe 1.3 per cent off CPI.
The VAT changes could delay December inflation figures by up to two weeks as it impacts pricing calculations.
Experts are now predicting months of negative inflation next year, although many do not believe that the UK will suffer a period of sustained deflation.
Hetal Mehta, senior economic adviser to the influential 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 one per cent threshold.”
The minutes of the Bank of England’s latest interest rates meeting will shed more light on the monetary policy committee’s thinking on inflation and rates.
There are reportedly concerns that the weakness of the pound may prevent the Bank from cutting rates as fast as they would like.
The performance of the pound has been hit hard as inflation expectations have plunged.
JP Morgan Chase economist Malcolm Barr stuck by predictions for a further half point rate cut in January – to 2.5 per cent – despite the currency concerns and higher than forecast November CPI data.
“We remain comfortable with the call for a further 50 basis point move in January at this stage, with the move reflecting a compromise between data that suggest an ongoing need to act aggressively versus concern on the rapidity of weakness in the currency,” he said.