Question of the week: Would CPI Inflation be above the 2% target, if the government had not cut VAT?
A: Ignore the 2.3% rate of the CPIY measure of inflation, which in theory removes the impact of indirect tax changes from the CPI. It crudely assumes that firms pass on tax changes in full to consumers. It infers, therefore, that pre-tax prices have rocketed in the catering and accommodation services sectors, because they didn’t reduce prices by the full 12.5% in response to the VAT cut to 5%, from 20%, in mid-July. But in reality, choosing not to pass on savings from a tax cut is very different to pushing through price rises. In our view, a better gauge of underlying price pressures is CPI inflation excluding components affected by the VAT cut. Our first chart below shows that it was just 0.9% in October, well below its 1.7% rate in January, and not far above the 0.7% inflation rate for the overall CPI.
Granted, without the VAT cut, businesses might have increased prices a little since July, to offset the extra costs incurred by complying with Covid-19 rules. But we know from July's CPI data—which captured the period after these firms reopened but before VAT was cut on July 15—that they chose instead to absorb the vast bulk of any Covid-related costs.
For sure, consumer demand for many services might begin to surge in Q2, when meaningful numbers of people likely will have been vaccinated against Covid-19. The inflation rates for airline fares, package holidays and accommodation services all look set to jump in mid-2021. But at the same time, prices for goods currently in high demand—cars, recreational goods, computers and bikes—will fall back. Indeed, core goods inflation likely will undershoot the current low rate of producer output price inflation in 2021, having overshot it this year. Note too that prices for some services, such as train fares and mobile phone contracts, are automatically linked to past rates of inflation, so they will rise by less in 2021 than they have this year.
Accordingly, our second chart shows that we continue to doubt that CPI inflation will rise on a sustained basis back to the 2% target in 2021.
Senior U.K. Economist