LONDON (Reuters) - Inflation could take an extra year to fall back to its 2 percent target if a widely expected hike in value-added tax takes place, potentially causing an earlier start to Bank of England interest rate rises.
Policymakers would normally ignore such one-off rises in prices but a potential problem already identified by the Bank of England is that inflation has already been way above target for some time at a point when interest rates are at a record low.
The worry is that this could lead to a big shift up in inflation expectations as people come to assume that prices will keep going up at such a speedy rate and start demanding wage rises effectively fulfilling their predictions.
“There are a lot of ifs buts and maybes, but I think at the end of the day a VAT rise could potentially bring forward a rate hike,” said Philip Shaw, economist at Investec.
Most economists expect the BoE to wait until the turn of the year to raise interest rates from their record low of 0.5 percent and start withddrawing the 200 billion pounds of stimulus they have thrown into the economy.
But some policymakers are clearly getting worried that rates are too low and inflation is too high when the economy is getting better.
“The recovery in the economy and the resilience of inflation highlight the issue of how long expansionary policy will remain appropriate,” Monetary Policy Committee member Andrew Sentance wrote in a newspaper on Sunday.
Many economists see a rise in VAT to 20 percent from 17.5 percent as the likeliest way that Britain’s new coalition of Conservatives and Liberal Democrats will raise taxes to narrow a budget deficit that has swollen to 11 percent of GDP.
Such a move could add anything from 0.8-1.0 percentage points to consumer price inflation, which hit a 17-month peak of 3.7 percent in April, more than double euro zone levels.
Data released on Tuesday showed inflation dropped to 3.4 percent last month, and the BoE forecasts inflation will be back below 2 percent by early next year. Past oil price rises are set to fade from the data and spare capacity from Britain’s deepest recession since World War Two should bear down on prices.
This assumes that none of the upward surprises that have plagued British inflation over recent years take place, and as BoE forecasts are based solely on announced government policy, it does not account for a possible VAT rise.
Conservative Chancellor George Osborne has refused to rule out increasing VAT — which is lower than the EU average — both before the May 6 election and since.
VAT, income tax and national insurance — a wage tax split between workers and employers — are three sources of tax revenue for the British government, and the coalition has said a fifth of fiscal tightening will be achieved by tax rises.
Should Osborne opt for a VAT rise, the exact path of inflation would depend on whether the rise is implemented straight away, or deferred until the start of 2011 when the economy may be stronger.
If the latter, then it could be the end of 2011 before the effects of the VAT rise drop out of the CPI data and inflation falls to 2 percent, a full year later than otherwise, according to Howard Archer, economist at IHS Global Insight.
Textbook economic theory on central bank rate-setting suggests that rises in inflation caused by one-off effects such as tax rises do not need to be tackled by higher interest rates.
BoE Governor Mervyn King said as much when VAT rose at the start of the year, pushing inflation above 3 percent and forcing him to write a public letter of explanation.
The exception is if employees and retailers lose confidence that inflation will return to target in the medium term, and start demanding bigger pay deals and pre-emptively raising prices to compensate for higher long-term inflation.
Archer said a loss of confidence was a danger, given high inflation and a recent leap in the BoE’s own inflation expectations index. But he said a second round of price rises was less likely due to the economy’s weakness.
“Given the labour market’s still fragile, I’m dubious, even if there was a big spike up in inflation expectations due to the VAT hike, of how much of a follow-through there’d be,” he said.
Inflation stayed under control when a previous Conservative government raised VAT to 17.5 percent from 15 percent in 1991. But there were much more lasting effects from the rise in VAT in the June 1979 budget, when Margaret Thatcher’s new government raised VAT to 15 percent from 8 percent for non-luxury goods.
Shaw said that the BoE would definitely have to stress to the public that higher inflation was temporary if VAT rose, and that it may tip the balance towards earlier tightening.
“If the economy is weak and Osborne announces big spending cuts, it’s hard to see the MPC tightening policy and risking recovery,” said Shaw.
“But if the economy gains traction, then if the MPC is concerned about its credibility the prevailing headline rate of inflation could have an impact on the timing of tightening.”
Editing by Patrick Graham