UK Inflation

The UK has two major ways of measuring inflation - now called CPI and RPI. The Government's prefered measure is CPI and currently rests at 2.1%, a little above the Bank of England's target of 2%. Normally, in this situation, the BoE would increase interest rates a little to slow down the economy - but it hasn't done so for a number of reasons:

Firstly, they are already very high at 5.75% for the base rate - this is damaging our trading position - last month saw a record current account deficit at £-4.7bn. The high interest rate also incidentally inflates our purchasing power, making us look richer in world terms than we really are - as the Americans found to their cost fairly recently when the currency value went through a sharp correction.

Secondly, it already looks as though there are problems in the economy that will make it slow during the next year - the collapse of Northern Rock, the rippling effect of the credit crisis in the US and the nervousness this is creating on the stock market and in banks' lending decisions.

Thirdly, the high levels of debt in the UK - now above £1 trillion - equal to the whole GDP of the UK, is likely to affect retail sales in the new year.

So, the BoE is trapped. It knows it should raise interest rates but it can't do it. Meanwhile, the RPI - the other measure of inflation - has risen to a dangerous 4.2%. Most economists would argue that once inflation pushes above 4%, money illusion fails and people begin to notice. They then start agitating for pay rises and this can then lead to other forms of economic disruption.

The next year will be an interesting one for the UK economy.