Is inflation falling too far and too fast in 2012?

Inflation continues to fall back in 2012.

But could it be falling too far and too fast?

Here we look at latest inflation data and assess the extent to which inflation might be expected to fall in 2012.

Latest inflation data: Inflation plummets
The latest official inflation data from ONS showed a sharp fall in inflation, as the influence of the January 2011 VAT hike fell out of the monthly figures:

• Consumer prices index (CPI) inflation stood at 3.6% in January 2012, down from 4.2% in December 2011. CPI has now come in above the upper end of the Government's symmetrical target of one percentage point either side of 2% (i.e. within the range of 1% to 3%) for two full years. In other words, CPI has been at or above 3% for each month since January 2010.
• Retail prices index (RPI) inflation stood at 3.9% in January 2012, a fall of 0.9 percentage points from 4.8% in December.
  

Most commentators believe inflation will continue to fall. For example, the British Chambers of Commerce (BCC) said yesterday that it expects CPI to average 2.7% during 2012, while RPI will run at 3.2%. This could well have some positive implications for UK households. Chief economist David Kern says "falling inflation will ease the squeeze on living standards."

Is inflation falling too far and too fast in 2012?
However, the Bank of England is now concerned that CPI inflation could, if anything, fall too far, too fast. The Bank of England Monetary Policy Committee (MPC) voted at its February 2012 meeting to extend its programme of quantitative easing by a further £50 billion, taking its total to £325 billion (for more on this decision, and an explanation of what quantitative easing entails, click here).

The decision to extend quantitative easing is primarily driven by the desire to boost growth. But the MPC also hopes that it will help buoy up CPI inflation, which is in danger of undershooting its 2% target rate.

2011 research from the Bank of England found that quantitative easing applies upward pressure to inflation.

How far and how fast will inflation fall?
So just how far and how fast will inflation fall?

The latest quarterly Bank of England Inflation Report notes that "how fast and how far inflation will fall remain uncertain, and will depend, in part, on the strength of demand." Its central forecast is for inflation to "continue to decline during 2012 to below the 2% target by the beginning of next year. [...] Further ahead, inflation is projected to rise slowly back towards the target, as the margin of economic slack gradually diminishes, and businesses continue to restore profit margins that were squeezed during and after the recession."

A number of other factors could also serve to push up inflation over the coming months, including the following:

• A spike in gas prices caused by recent cold weather.
• "Disruptions to the supply of oil, for example from Iran or Nigeria, could pose an upside risk to the inflation outlook," says Mervyn King. Indeed, the Evening Standard reports that - in its words - "sabre-rattling by Iran" is already pushing oil prices upwards. Petrol prices hit a record high of 137.44p at the weekend, the BBC reports.