'Sticky' prices lift hopes of recovery

Unchanged inflation figure suggests UK has seen off worst of the recession

Inflation stayed higher than expected last month, suggesting that demand may be picking up and the economy edging closer to recovery. The Office for National Statistics said that the Consumer Prices Index remained at 1.8 per cent in July, while the older- established Retail Price Index showed a technical increase in inflation, that is a reduction in deflation.

According to the RPI, prices fell by 1.4 per cent in the year to July; but they fell by slightly more, 1.6 per cent, in the year to June. So-called "core" inflation, which excludes the effects of highly taxed and volatile and seasonal items – such as food, petrol and tobacco – was up, showing a rise of 1.8 per cent on July last year, compared with a rise of 1.6 per cent in the year to June. Economists take this measure as the best for determining fundamental trends.

The RPI also includes mortgage interest costs, which are excluded from the CPI. The radical reduction in interest rates since last year explains why the RPI has been negative since March. In July, for example, mortgage interest payments were running, on average, 45 per cent below their levels last year.

In terms of what has been keeping inflation relatively "sticky" recently, the ONS pointed to a rise in the cost of games, toys and hobbies as the largest upward pressure on inflation. However a sharp decline in the rate of food-price inflation, which was running at double figures for most of last year, and is down to about 4 per cent now, helped to dampen both the CPI and RPI.

The news means that the Bank of England forecast, predicting that CPI inflation would fall to below 1 per cent by the end of the year, may not be met, and that the Governor, Mervyn King, will not have to write an open letter of explanation to the Chancellor. Mr King is obliged to do this if inflation moves more than 1 per cent in either direction from its 2 per cent target. It also suggests that the Bank may tighten monetary policy sooner than expected if inflation does indeed appear to be returning to the 2 per cent level faster than anticipated.

The effects of last year's Budget fiscal stimulus of about 2 per cent of GDP, plus a massive programme of quantitative easing, recently extended by £50bn to £175bn, seem to be feeding though to spending. Indeed, some observers believe that the recession is over, and that the UK will join France, Germany and Japan in the economic recovery room when the third quarter GDP data is released in October.

Economists also believe that inflation will head higher early next year in any case. They say that the reversal of the VAT increase in January and other "baseline effects", and previous cuts in energy bills and mortgage rates starting to fall out of the annual index, will push inflation up again, and higher than the Bank of England's target.

Michael Saunders, head of European economics at Citigroup, explained: "If, as we expect, next year sees above- consensus economic recovery and above-target inflation – albeit lifted by temporary tax effects – then the MPC will probably start to move away from the current ultra-loose stance."

Although it has strengthened in recent months, the 20 per cent depreciation in the value of sterling since 2007 has also helped to push inflation higher than it might otherwise be.

Trends in wages growth and unemployment indicate that there will be little impact on incomes growth from the stabilisation in inflation anywhere in the economy. The Chartered Institute for Personnel and Development said yesterday that one in five public-sector employees have had their pay frozen, identical to the proportion of private-sector employers currently freezing staff pay.