Annual consumer price inflation fell unexpectedly to 2.0% in December, ending a four-year overshoot of the Bank of England’s target*. The level of consumer prices, however, is 7.4% higher than if the Bank had achieved 2.0% inflation consistently since the end of 2003, when the current target was established.

The decline from 2.1% in November mainly reflected another significant drop in food inflation – down to 2.1% from a recent high of 5.0% in April. The food drag may be approaching an end: food producers’ price-raising plans rebounded in late 2013 – see first chart.

The focus here is on “core” inflation, i.e. excluding energy and unprocessed food and adjusted for the impact of changes in VAT and undergraduate student tuition fees. This fell to 1.8% in December, matching a low reached in October. Core inflation peaked at 2.9% in March 2012.

It is important to recognise that inflationary trends reflect monetary conditions about two years ago; they are of limited relevance for judging whether the MPC’s current policy stance is appropriate.

The money supply backdrop was very weak in 2011 but strengthened significantly in 2012-13. Annual growth of broad money, as measured by non-financial M4, rose from a 2011 low of 1.5% to a peak of 5.6% in April 2013. The narrow M1 measure improved more dramatically. Faster monetary expansion correctly signalled current economic strength and suggests that core inflationary pressures will revive during 2014.

Inflation expectations, moreover, remain elevated despite the recent headline decline. Current gilt yields imply retail price inflation of 3.3% in five years’ time, above an MPC-era average of 2.9% and inconsistent with the 2.0% CPI target – second chart. A household expectations measure derived from the EU Commission consumer survey is similarly high relative to history and has firmed recently – third chart.

The main risk to the pessimistic inflation view here is a further significant rise in the exchange rate, echoing a 1996-97 surge four years after sterling’s expulsion from the European exchange rate mechanism – fourth chart. The balance of payments position, however, is much weaker now than then: the current account was close to balance in 1997 versus a deficit of 3.8% of GDP in the first three quarters of 2013.

*The last month at or below 2.0% was November 2009 (1.9%).