UK inflation has been falling, driven mainly by a fall in consumer demand, and last year’s VAT increase falling out of the year-on-year comparisons.  Looking under the bonnet, however, reveals a disconnect between inflation of ‘necessary’ and ‘discretionary’ goods.  The inflation of ‘necessary’ goods is falling, while that of ‘discretionary’ continues to steadily rise.  When people perceive that inflation will erode their savings, they are more likely to spend now, even on items that are not essential.  This was a paradox of Weimar Germany.

Visitors to the country saw wealth and prosperity, theatres full and the best restaurants packed.  This masked the real story: those that had money were spending it, and spending it faster than ever before as inflation rapidly diminished their wealth.  Indeed, inflation expectations in the UK remain elevated (they have fallen from their peak last year, but are on the rise again, according to YouGov/Citi).

Mervyn King, Governor of the Bank of England, used the recent fall in inflation (and thus a fall in their inflation forecast) to justify another round of quantitative easing, citing there is now “downside” inflation risk.  This once again displays the exquisite ability of central bankers to base policy on the past, not the future; the VP Future Inflation Index, which gives a 6m lead on UK CPI, has already turned up.

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