Inflation could reach 16-year high of 4.5 per cent, warns City

Mervyn King, Governor of the Bank of England, is expected to reveal this week that inflation in Britain has surged to a 16-year high of 4.5 per cent – 2.5 per cent higher than the target level prescribed by the Government. Mr King will once again be forced to write a letter to Chancellor Alistair Darling explaining why prices have leapt so high.

The Government's chosen measure of inflation, the consumer price index, hit 3.8 per cent last month, but is widely expected to increase substantially as food and energy costs continue to rise.

"The Bank of England will have to increase its inflation forecasts, revising CPI to at least 4.5 per cent with the potential to rise to just under 5 per cent in the third quarter of 2008," said the Bank of America economist Matthew Sharratt.

He said that the Bank was caught between two stools: wanting to bring down interest rates as the economy slows and trying to keep a lid on inflation. He added that the rise in prices will strengthen the idea that rates will be kept on hold for the next few months.

Howard Wheeldon, senior strategist at broker BGC, said inflation would "certainly" hit 4.5 per cent but that would probably signal its peak. "With the rising cost of energy and food, inflation is not likely to go down any time soon, though it should stay below 5 per cent.

"The third quarter will be tough but the fourth quarter may begin to see a fall in inflation. The Bank will do its level best to prevent rates rising, but will hold for the next two to four months, before we might see a fall."

Economists widely expect that inflation will start to decline at the end of the year, and could be under 3 per cent in early 2009.

Weak housing data from the Royal Institution of Chartered Surveyors and evidence of slowing activity on the high street from the British Retail Consortium will be released this week, increasing calls for the Chancellor to cut the cost of borrowing.