Why UK inflation rate appears divorced from reality but could change

Inflation, the official figures tell us, hardly exists. It is so low, and stable, that it should not be a talking point.

The annual increase in average prices crept up to 0.7% last month, from 0.5% in September. That means the basket of goods and services used by the Office for National Statistics to judge consumer price inflation (CPI) has barely moved over the last year.

It might have proved the opposite of a surprise to City analysts who had pencilled in a near constant 0.6%, but to everyone else it must be mystifying that prices in two completely different eras – before and after the pandemic – are virtually unchanged.

When the ONS says the falling cost of holidays dragged down the average for October, it shows that most people’s day-to-day experience, where cut-price package holidays are a pipe dream, have become divorced somewhat from the inflation figures.

Likewise cinema ticket prices fell. But who was buying them last month to enjoy the financial benefit? Not many after UCI and several other cinema chains closed their doors.

Another reason can be found in the unprecedented financial support from the government to help businesses during the pandemic. One measure in particular has affected inflation and that is the cut in VAT from 20% to 5% for the hospitality industry.

This tax cut registers as a fall in prices, dragging down the average.

Andrew Sentance, a former Bank of England policymaker, said if taxes had been kept constant, CPI would be 2.4% – above the Bank’s target for inflation of 2%.

The mania for home improvement, driven by the rules that keep most people at home, provides another reason for scepticism.

While there are people who are able to indulge their passion for DIY, others must commission specialists to complete the job.

A backlog of work from the first lockdown and increased demand have put pressure on all trades connected to home improvements and, more importantly for lower income households, maintenance.

In most parts of the country it can be two or three months before a builder, decorator, plumber or electrician can find a space in their busy diary. Anecdotal evidence says prices are rising in line with the mismatch in supply and demand.

To some extent the official figures reflect this trend, with the cost of a carpet layer increasing by twice the average inflation rate over the last year. But according to the ONS it costs no more to employ an electrician this year than last, or more precisely the price increased 0.1%.

Sentance, now a senior adviser to Cambridge Econometrics, says the VAT cut, if it is reversed in January as planned, will push inflation up strongly.

Adding to the pressure on prices, the arrival of several vaccines could also ease lockdowns and see an increase in consumer confidence and spending.

Such a trend would be a repeat of 2011, when the recovery from the 2008 financial crash pushed inflation towards 5%.

It’s true the increase proved to be a temporary blip and was ignored by the Bank of England, which kept interest rates at near zero.

But it was a difficult time for households. Wages remained low and disposable incomes fell. For many, the same could be happening again.

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