The UK's inflation headache

Will Hodges reports on the rising rate of inflation and explains how it affects the economy – and you

Just when you thought it was safe to go back into the supermarket, inflation is rising once again. The latest figures released by the Office for National Statistics (ONS) revealed that the rate of inflation rose to a seven-month high of 2.7 per cent in December 2012 - some way above the Bank of England (the Bank)'s 2 per cent target.

Rising inflation is casting further doubt on the already-shaky prospects of a UK economic recovery in 2013. It's also becoming an increasing concern for economists anxious about the possibility of a triple-dip recession after a weak economic performance in the final quarter of 2012. UK GDP is expected to grow by 0.9 per cent this year, but it risks being weathered by a squeeze on consumer spending as a result of inflation, as well as cold economic winds from the eurozone.

Up, up and away

A low, stable level of inflation is generally considered to be a good thing for an economy because a steady rise in the price of goods, of around 1 to 3 per cent a year, encourages productivity. But when inflation rises faster than wages, it erodes peoples' disposable income and causes us to spend less on products such as cars, entertainment and holidays.

The recent rise in inflation has been blamed on soaring gas and electricity bills, as five of the UK's six major energy providers introduced price increases in December 2012, affecting 25 million households across the country. Food price inflation also remained high in December, at 3.8 per cent, and is likely to accelerate further in the coming months.

What's more, the timing of the inflation surge is particularly wretched. The austerity measures put in place by the coalition have prompted wage freezes in much of the public and private sector, hitting peoples' pockets everywhere. The average income of professionals in the private sector is forecast to grow by just 2.2 per cent in 2013, while wage increases for public sector workers have been capped at 1 per cent per year. In real terms, this means many people are suffering a pay cut, and won't have any extra cash to spend.

With personal consumption accounting for around two-thirds of all spending in the UK - and the same amount of UK GDP - even a marginal rise in inflation levels, combined with austerity, will reduce consumer spending and impact on economic growth.

What's the remedy?

The rate of inflation has been running above the Bank's 2 per cent target since November 2009. Many analysts fear it will soon break through the 3 per cent ceiling, which would force the Monetary Policy Committee (MPC) - those responsible for setting the target and managing monetary policy to achieve it - to issue a letter of explanation to the Treasury. In November 2012, the MPC predicted that inflation won't fall until the third quarter of 2013, but many economists believe it's unlikely to drop back below 2 per cent until 2014 at the earliest, with Barclays Wealth not expecting it to return to "normal" levels until the following year.

The likelihood of further inflation over 2013 has led to calls for the Bank to take its foot off the pedal of its quantitative easing programme - the process whereby the government injects cash into the economy in order to encourage banks to lend more readily to businesses. Too much government stimulus and inflation is likely to rise further, because pumping more money into the system drives prices higher. As a result, consumer spending will be squeezed and the UK's economic recovery undermined. On the flip side, some say the only remedy is for the government to abandon its 2 per cent inflation target and free up additional stimulus to try to boost growth.The conundrum is one which threatens to come increasingly to the fore over the coming months. Inflation is back, and taking centre stage.