Petrol costs fuel jump in inflation

Bank of England Governor Mervyn King today insisted a jump in inflation to 3.5 per cent was "temporary" as the surge in January's figure triggered a letter of explanation to Chancellor Alistair Darling.

Mr King has to write a letter to the Chancellor in the event that inflation is more than 1 per cent above the Bank's 2 per cent target.

January's rate of 3.5 per cent was the highest level for the Consumer Prices Index measure of inflation since November 2008.

In his correspondence, Mr King said: "Although it is likely to remain high over the next few months, inflation is more likely than not to fall back to the target in the second half of this year."

He said the increase in VAT back up to 17.5 per cent, a 70 per cent hike in oil prices over the past year and the effects of sterling's depreciation had all played their part in the inflation spike.

Mr King said the Bank's Monetary Policy Committee believed the rise was a "temporary deviation" from the target.

He said that, in the longer term, the measure would be dragged lower by weak spending, which has created a "substantial margin of spare capacity within the economy". This has already been seen in weak wage growth, he added.

The Governor said the effects of the Bank's £200 billion quantitative easing (QE) programme to boost the money supply and record low interest rates would continue to aid the economy for some time.

He said the MPC was ready to take "whatever actions are necessary to ensure the outlook is for inflation to remain in line with the 2 per cent target".

Mr King also reiterated his comments last week that the QE scheme - which has recently come to a halt - could be restarted if needed.

But he also said that, if inflation looked likely to rise above target in the medium term, monetary policy could be tightened.

In his response to Mr King's letter, Mr Darling said the inflation outlook was "subject to some uncertainty" as the world emerges from the "deepest downturn in modern times".

Mr Darling indicated that austerity measures were on the way in the coming years.

He added: "Over the medium term, setting a credible consolidation path to ensure sound public finances is a key element of the Government's macro economic strategy, and it is essential for economic stability and the long-term health of the economy."

January's VAT rise was the biggest factor in forcing CPI to 3.5 per cent, according to the ONS.

The Government reduced VAT to 15 per cent on a temporary basis until last month in a bid to boost consumer spending and ease the recession, but its reversal back to 17.5 per cent was always expected to have an impact on inflation.

The ONS said that, as a result of VAT, the monthly change in the all-item CPI index fell by just 0.2 per cent between December and January - traditionally a time when prices fall.

It was the smallest decline since records began in 1996.

Higher fuel and transport costs also sent CPI up, with annual transport inflation, including the cost of cars, reaching a record 11 per cent.

Last month's adverse weather also impacted on the cost of certain seasonal vegetable prices, with cauliflowers rising by the highest amount since at least 1996 and the cost of carrots doubling.

Its figures also showed that the headline rate of Retail Prices Index (RPI) inflation, which includes the cost of mortgages and housing, also rocketed in January, to 3.7 per cent from 2.4 per cent.

The ONS said it would publish more details on the impact of VAT on inflation on April 20.

Economists expect CPI to start falling swiftly from the second quarter onwards.

Jonathan Loynes, chief European economist at Capital Economics, said today's release should help to reassure the Bank of England that the recent rise in inflation will prove to be only temporary.

He said: "With core inflation rising only from 2.8 per cent to 3.1 per cent, it looks like retailers offset much of the VAT effect. This might be a timing effect - retailers may have already raised prices in anticipation of the hike or will do so further in the next month or two.

"But it might also be the first sign that the vast amount of spare capacity in the economy is starting to weigh down on underlying price pressures."