Rate cut hopes hit as energy bills help drive up inflation to 2.5%

Inflation hit 2.5 per cent last month, up from 2.2 per cent in January, the Office for National Statistics said yesterday, narrowing the Bank of England's room for manoeuvre on interest rates.

The ONS said the sharp increase in the Consumer Price Index (CPI) was largely due to higher energy bills, particularly following a technical change in the way inflation is calculated. Previously, gas and electricity price changes were phased into the figures over a four-month period because prices do not change for customers until the day their meters are read. But the increases are now factored into the CPI when the change is made, so price rises announced over recent months are included in the February index.

The ONS said that, had the old methodology been kept, inflation would have been unchanged. Nevertheless, economists said the Bank of England might now be more cautious about lowering interest rates, even with the impact of the credit crunch and the more aggressive example set by the US Federal Reserve tugging in the other direction.

The Bank's view is that inflation from higher oil and food costs as well as the depreciation of sterling is "already baked in the cake", and will be temporary.

"Core" inflation – stripping out volatile items such as energy and food – actually fell last month, from 1.3 to 1.2 per cent.

In his Budget last week, the Chancellor, Alistair Darling, forecast inflation of 2.5 per cent for 2008, and of 2.75 per cent for fiscal 2008-09.

Inflation as measured by the Retail Price Index (RPI), the reading followed by wage bargainers and used to uprate state benefits, held steady at 4.1 per cent in February. Lower house prices helped keep this measure subdued.

Despite the technical change, the escalating cost of energy will have a marked impact on household budgets and inflationary expectations, as it is a"high-visibility" item, like supermarket bills andforecourt petrol prices. Gas prices rose by 12.5 per cent and electricity prices by 10.6 per cent in February alone. The cost of heating and lighting a home is almost 50 per cent higher than in 2005.

Petrol and diesel were about 20 per cent higher than in February 2006, the fastest rate of increase for more than a decade, while the increase in the cost of milk, cheese and butter, at 17 per cent on the year, is also the highest since the series began in 1997.

The ONS said the effect of the Budget increases in excise duty and other taxes would be 0.06 per cent of the CPI.

The acceleration in inflation makes it more likely that the CPI will breach the 3.1 per cent mark this year, probably in July or August.

At that point, it will be more than 1 percentage point above the official target, and will trigger a letter of explanation from the Governor of the Bank of England to the Chancellor of the Exchequer. This would be the second such missive in 18 months.