By: Dr. Mike Campbell

One of the functions of the Monetary Policy Committee (MPC) of the Bank of England is to keep inflation in check. The target level for inflation in the UK is 2% and the Governor of the Bank of England is required to write to the Prime Minister, David Cameron, to explain the situation if inflation exceeds 3% in the UK. However, the MPC is also responsible for ensuring financial stability, confidence in the UK currency and, of course, setting interest rates.

The Bank, in common with most major central banks, has adopted a policy of low interest rates which are designed to encourage economic activity by provision of “cheap” money to business. It was the case for quite a while that the MPC were divided on the wisdom of maintaining a low interest rate at the expense of higher inflation. However, increases in VAT which came in last January and the government’s austerity measures were judged to have an easing effect on inflationary pressure.

The December reading of the UK Consumer Price Index (CPI) has shown that inflation eased significantly from 4.8% to 4.2%. In addition to the effects of the tightening of the public purse, cheaper clothing and fuel prices were responsible for the improved data. The fall in inflation is the largest monthly drop since April 2009 and takes inflation back to the level seen last June.

The effect of the VAT rise will fall out of the statistic soon and it is anticipated that there will be further falls in the price of energy, so analysts expect inflation to fall back to 3% by the spring. The Bank is predicting that inflation will return to its target range by the end of 2012.