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WEEKLY ECONOMIC REVIEW

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After two months when the underlying rate of retail price inflation was 3.3%, compared to his target range of 1 to ...
After two months when the underlying rate of retail price inflation was 3.3%, compared to his target range of 1 to 2.5%, the chancellor will have welcomed last week's announcement that it fell to 3.1% in December. This fall certainly will have helped him justify to the governor of the Bank of England the decision not to raise base rates this month.

The fall in inflation in December was mainly due to lower motoring costs (petrol prices) and lower food prices. These brought goods price inflation down to 2.7% (from 3.2% in November), while service sector inflation rose from 2.8% to 2.9%.

Underlying these trends is the recent strength of sterling. The service sector is largely insulated from overseas competition and imports make up only a tiny fraction of its total costs. Hence, the rise in sterling's value last year has little impact on prices. Instead, the steady strengthening of consumer demand is leading to a gradual creep up in service sector inflation.

Goods prices, however, are impacted by the currency. The rise in sterling makes imports cheaper, reducing domestic manufacturers' costs, but also making it necessary for them to restrain price increases if they are to compete with overseas companies. There are also direct benefits from a strong currency. Last year's 16% gain in sterling has gone a long way to offset the rise in oil prices on international markets. Hence, the good news on petrol prices in December. It is also making food imports cheaper too.

Looking ahead to the next few months, there should be more good news on inflation. Food prices rose sharply in the first few months of 1996. That is unlikely to be repeated this year. And there should be a revaluation of the 'green pound' in coming months, which will reduce the costs of foodstuff imported from the EU.

If the general election is held on May 1st, which is still most commentators' expectation, the last published inflation data will be for March. This is likely to show an underlying rate of around 2.8%, below the current rate, but above the chancellor's target range. The opposition will present this as a failure, though in the light of the UK's inflation history of the last 30 years, it will actually be quite an achievement.

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