Further rate rises expected as inflation surges to 3 per cent

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The Independent Online

The odds on further increases in interest rates have shortened dramatically following news that inflation has surged to its highest in a decade.

Inflation on the consumer price index measure rose to 3 per cent in December from 2.7 per cent the previous month, the highest since comparable records began in 1997 and way above the Bank of England's 2 per cent target.

However, the Bank's Governor, Mervyn King, was saved from the embarrassment of having to write a letter to the Chancellor, Gordon Brown - for now. Mr King is required to explain why inflation has veered so far off course, and what the Monetary Policy Committee intends to do about it, if it deviates more than one percentage point above or below the target.

"Whichever way you unpick these numbers, they will look bad to the MPC and they should be straining on the leash for another rate hike as soon as possible," said David Brown, economist at Bear Stearns. "Governor King might have avoided writing a letter to the Treasury by the skin of his teeth this month, but it is just a temporary delay."

The MPC stunned the City and disappointed homeowners last week by unexpectedly lifting borrowing costs by a quarter-point to 5.25 per cent.

"Rates should be heading to 5.5 per cent in the near-term, and it is impossible to say that they will not be going higher, given the current belligerent mood of the Bank," David Brown said.

Howard Archer, economist at Global Insight, said CPI inflation could well exceed 3 per cent this month due to higher utility bills and less generous discounting in the January sales than last year.

Inflation on the alternative retail price inflation measure, which includes housing costs, was even higher. Headline RPI, the rate traditionally used in wage negotiations, rose to 4.4 per cent in December from 3.9 per cent the previous month, the highest since December 1991. The Bank will be concerned the increase will encourage inflationary pay demands in the crucial new year bargaining round, triggering a wage-price spiral.

Meanwhile, RPIX, which strips out mortgage costs, rose to 3.8 per cent from 3.4 per cent, the highest since October 1992. Until December 2003, the Bank's job was to hit 2.5 per cent inflation on the RPIX measure. Had the old target still been in place, Mr King would have had to reach for his pen today.

The Office for National Statistics, which published the figures, said the biggest boost to prices in December came from transport costs, which were driven higher by rising petrol prices and the fuel duty increase announced by the Chancellor in December's pre-Budget report.

Furniture prices also contributed to inflation pressures, shooting up last month by a record 8.7 per cent, as retailers raised prices before the January sales. The jump wrong-footed analysts, most of whom had predicted CPI would nudge up to just 2.8 per cent.

The figures came as Andrew Sentence, a member of the nine-strong MPC, shed some light on last week's rate decision. He said the move was aimed at controlling demand and firmly anchoring inflation expectations.

"If inflation is to be brought back to target and to remain there, demand needs to be appropriately restrained and expectations of inflation by wage and price-setters must remain consistent with the 2 per cent CPI target," Mr Sentence said in a speech in the City.

The Prime Minister Tony Blair claimed that inflation had risen in most major countries due to soaring energy prices, but Britain has the highest inflation of all the G7 rich nations - by some margin. Inflation in the US and Italy is running at 2 per cent, in France it is 1.6 per cent, in Germany 1.5 per cent, in Canada 1.4 per cent, and in Japan it is languishing at 0.3 per cent.

The letter the Governor might have written to Brown

Dear gordon,

I am writing to explain why inflation has risen more than one percentage point above the target you have set the Bank of England's Monetary Policy Committee. I know it doesn't look good but, the thing is, it really isn't my fault. If I may be so bold, I would even venture to suggest that some of the blame must lie at your door.

In your Pre-Budget Report in December, you announced that you were putting up fuel duty for the first time in three years. While I understand that you are keen to demonstrate your green credentials, the move added about 1.5p to the cost of a litre of unleaded petrol and did little to help our fight against inflation.

Indeed, one of the main reasons for the rise in inflation announced today is a big jump in the cost of transport. Then there is the issue of tuition fees. Thanks to your Government, universities started charging students as much as £3,000 in fees when the new academic year started in September.

While it is not my place to suggest that this will deter many young people from higher education, can I point out that the annual rate of increase in the cost of education has nearly tripled from 4.7 per cent in August to 14 per cent today as a result of your policy.

It's not all your fault, of course. As powerful as you are, even you cannot control global oil prices, which have also contributed to rising inflation. But then neither can we. The price of food has also been rising quite sharply over the past few months. We blame global warming. In fact, if you strip out food and energy prices, inflation is running at just 1.8 per cent.

So, you see, a large part of the increase is beyond our control. Nevertheless, we take our remit very seriously and that is why we have increased the base rate three times since last August.

As a committee, we will continue to monitor economic conditions at our monthly meetings to ensure we remain on track to meet the inflation target over the medium term.

Yours sincerely Mervyn King