Inflation: what happens now

Today's letter exchange between Bank of England Governor Mervyn King and Chancellor Alistair Darling is expected to mark the start of an extended correspondence as the cost of living surges.

Inflation, as the Governor warned in May, could stay above the 3 per cent letter-writing threshold for "several quarters" as record oil prices, higher food costs and dearer energy bills heap pressure on households.

Mr King has only been forced to write to the Chancellor once before. In March last year petrol, food, and an unexpectedly sharp rise in gas and electricity bills triggered a rise in the Consumer Prices Index (CPI) to 3.1 per cent and the first explanatory letter since the Bank's independence in 1997.

Then, the Governor could say the inflation spike was a short-term blip which would be eased as the price-cutting war among UK energy firms fed through to households - a point proved later in the year as CPI fell below the 2 per cent target.

But the problems now faced by policymakers are on a different order of magnitude little more than 12 months later in a global economy shaken by the credit crunch.

JP Morgan economist Malcolm Barr warned: "Inflation concerns are likely to intensify in the coming months.

"In the absence of a marked fall in global commodity prices, the period of high inflation and letter-writing from the MPC is likely to extend into the second quarter of 2009."

Between February and March last year the price of crude oil jumped around 25 per cent to about 64 US dollars. But oil is currently at more than double that price - threatening to push above 140 dollars and prompting some predictions that it could surge as high as 250 dollars.

This has left businesses creaking under the strain of input costs rising at a rate which seems to shatter new records every month, and being increasingly forced to pass on the rises to customers.

Mr King's "nice" decade of non-inflationary consistent expansion has turned decidedly nasty.

The commodity shock - not just oil, but metals and food products as well - has been matched by global financial panic over the rash sub-prime lending of the boom years, putting a sharp brake on lending for firms and consumers alike. This has fed into a slowdown in the property market, hitting consumer confidence and dragging back economic growth.

With people now saving rather then spending as a result of the uncertain outlook, a rougher landing for the UK economy than expected by the Bank's Monetary Policy Committee (MPC) when it raised interest rates five times in the 11 months to July last year could be on the cards.

But minutes of the MPC's meetings have signalled the inflation target will remain paramount for the MPC. With CPI due to rise near 4 per cent later this year, borrowing costs are unlikely to come down any time soon to encourage economic growth.

A weakening pound has also added to inflationary pressure, while energy firms are hinting darkly about more price hikes to come after a round of rises in the first three months of the year.

The Bank's rate-setters were given another headache last week when its latest quarterly survey of inflation attitudes - which could feed into wage demands - showed the public considered the current rate of inflation 4.9 per cent and expected it to average 4.3 per cent over the coming year.

Some City pundits are pricing in the possibility of interest rate rises due to soaring CPI - a move which would dismay millions of homeowners and borrowers and risk plunging the UK headlong into recession.

Mr Barr does not rule out the move. He added: "We do not expect the MPC to tighten (rates) in response to its current inflation concerns, but with inflation expectations rising the possibility of a modest "signalling" move cannot be dismissed."

Minutes of the MPC's latest June meeting - when rates were held at 5 per cent - will also be studied closely for signals of a possible rate rise on Wednesday. The committee's unswerving mandate to keep a lid on pricing pressure could lead to some tough medicine ahead for the UK economy before slowing demand brings inflation back under control.