Bank warns inflation spike could jeopardise interest rate cuts

Inflation is set to rise sharply, potentially jeopardising the chances of interest rate cuts, the deputy governor of the Bank of England warned yesterday.

"We have seen big rises in the world prices of oil and food," said Sir John Gieve. "That is being amplified in the UK by a fall in sterling and is now coming through in our food, petrol, gas and electricity prices. These are likely to raise our inflation rate well above target in the coming months, at a time when short-term inflation expectations remain uncomfortably high," he added.

Inflation is already marginally above the Bank of England's 2 per cent target, with the consumer price index standing at 2.1 per cent in December. The Bank now has to weigh the dangers of a sharp increase – on Monday, it revealed factory gate prices are now rising at their fastest rate for 15 years – against the challenging economic environment.

Sir John said the latter was a crucial consideration for the Bank's Monetary Policy Committee (MPC). "[The] case for easing interest rates has been greatly strengthened by the disruption of global credit markets and in our own banking system which brings a risk of a deeper downturn," he said. "This combination of upside and downside risks complicates our task of keeping inflation on track to meet the 2 per cent target."

But while Sir John noted that he has recently argued for rate cuts, he warned: "The current situation is complicated by emerging upward pressures on prices ... Demand from emerging economies may mean commodity prices prove resilient to slowing growth in the industrialised economies."

The Bank's acknowledgement that the UK faces a combination of slower growth and higher inflation – "slowflation" – was borne out by the latest survey from the British Chambers of Commerce. The BCC said yesterday that more firms planned to raise their prices at the end of last year than at any time in a decade – even though demand had noticeably weakened.

Sir John said that if the Bank were to cut interest rates rapidly in the face of resurgent inflation, the approach would need "careful explanation in the months ahead".

The governor of the Bank is obliged to write a letter of explanation to the Chancellor of the Exchequer if the rate strays by more than 1 per cent from the 2 per cent target. He has only had to do that once in the decade-long existence of the MPC, when last April inflation surged to 3.1 per cent.

Mervyn King blamed rising energy prices for the spike, but another letter, which could be required just as Mr King is due to be re-appointed in June for a second term at the Bank, would be very embarrassing.

Yesterday, Sir John said: "We face a sharp rise in inflation in coming months as a result of rising commodity prices worldwide and a fall in our exchange rate."

On its trade-weighted index, the pound has declined by 10 per cent since the autumn. Sterling's depreciation against the euro has been almost as steep as it was against the deutsche-mark on Black Wednesday.