Over the next few months, the data are likely to be dancing particularly vigorously under the influence of the reversal of the VAT cut, a turnaround in the stock cycle and even the effects of the recent cold weather. Added to that, the MPC is acutely aware that initial data releases are often later heavily revised, and there is uncertainty over the timing of fiscal consolidation. The patience of UK households is likely to be sorely tried over the next couple of years. There is little scope for growth in real take-home pay, which may remain weak even as output recovers. It is clear that inflation is likely to pick up markedly in the first half of this year, a message reinforced by this morning’s news that CPI inflation reached 2.9% in December. The continuing pass-through of the earlier significant depreciation of sterling, while part of the necessary rebalancing of our economy, is offsetting to some extent the downward pressure on inflation from the large amount of spare capacity. And the rise in VAT back to 17.5% means that CPI inflation is likely to rise to over 3% for a while, or even higher for even longer were energy prices or indirect taxes to increase further. Although such price level effects do not constitute a continuing source of inflation, and hence should be temporary, they remain in the official measure of inflation for a full year.
Some has in fact already been withdrawn with the return of the standard rate of VAT to 17.5% at the beginning of the month. But uncertainty about how and when fiscal policy will respond has a direct bearing on monetary policy. And markets can be unforgiving. As Federal Reserve Chairman Bernanke said recently about the similar fiscal position in the United States, “near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy  4  BIS Review 4/2010  economic growth”. The Chancellor has made clear that the Spring Budget provides the opportunity to do precisely that. Over the past year, the UK economy has battled against the headwinds of an intense monetary squeeze and a sharp fall in world trade, supported by the tailwinds of a huge policy stimulus and a lower exchange rate. At this very early stage of the recovery, it is particularly difficult to judge the medium-term prospects for the economy. Ten years ago, I described how movements in macroeconomic data can sometimes bear a “resemblance to oldfashioned disco dancing – sharp movements in unpredictable directions creating much excitement, accompanied by a good deal of noise”.