Sharp rise in inflation forces Bank of England to explain itself

Rising prices blamed on higher VAT, increased cost of petrol and the impact of bad weather on food supply
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A hike in VAT, higher petrol prices and bad weather helped push inflation to a 14-month high in January, the Office for National Statistics said yesterday. Prices rose by 3.5 per cent on the year, up from 2.9 per cent in the twelve months to December.

The Governor of the Bank of England, Mervyn King, has had to write a further open letter of explanation to the Chancellor explaining why the rate of inflation has strayed by more than 1 per cent from its official target of 2 per cent. It is the sixth such letter in three years. As recently as last September, annual price rises were down to 1.1 per cent.

In his letter, the Governor blamed "short-run factors" for the rise – the restoration of VAT to 17.5 per cent on January 1st; the 70 per cent rise in oil prices that pushed petrol higher; and the lingering effects of the depreciation of sterling over the past two years of about 25 per cent. Mr King added: "As was the case on previous occasions, the committee expects this to be a temporary deviation of inflation from the target, as was made clear in last week's Inflation Report.

"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, as the short-run factors wane and the influence of spare capacity builds."

Replying, the Chancellor agreed that the inflation outlook was "subject to some uncertainty" as the world emerges from the "deepest downturn in modern times".

The Governor's cautious tone suggests that interest rates will stay low for a protracted period, but there is a slight possibility that they could be raised sooner than assumed, as imported inflation – from commodity prices and the weak pound – outweighs the weakness of demand and spending at home.

The ONS said that over half the increase of 0.6 per cent in the annual rate of inflation was due to rapidly rising petrol prices – up 25.3 per cent on the year, from 86.3p per litre this time last year to 110.9p per litre now. Fuel prices have suffered a "double whammy" – higher VAT rates being levied on much higher underlying prices. Indeed motoring costs more generally have soared, driven up in particular, by used car values, which have climbed by 18.8 per cent, as companies and hire firms have delayed renewing their fleets and disposing of older vehicles. Motoring costs are up about a fifth on last year.

Duty that was increased on alcohol and tobacco when VAT was cut to 15 per cent was not reduced on January 1st, also pushing inflation higher.

The unseasonal weather over the winter has also taken its toll as crops were damaged by the exceptionally cold weather. The cauliflower was at the epicentre of this economic shock – up 59.7 per cent between December and January alone as the harvest in Britain and France was badly hit by frosts. Carrots, for similar reasons, jumped by 10.2 per cent in a few weeks.

The Retail Prices Index, which also reflects the cost of housing, rose to 3.7 per cent in January, from 2.4 per cent in December even as the effect of last year's radical cuts in mortgage bills and the stabilisation of house prices start to feed through to the indices.

However underlying inflation – removing volatile items such as food and fuel – is also edging higher, at 3.1 per cent annually, up on 2.8 per cent the previous month, suggesting underlying inflationary pressures, mainly from the weak pound.

Householders will also be deprived this year of the reductions in mortgage bills which were delivered throughout the latter part of 2008 and 2009 when the Bank of England cut interest rates to a record low of 0.5 per cent. Those on tracker rates and standard variable rates saw hundreds of pounds slashed from their monthly payments, as the bank tried to stimulate spending.

By the end of this year, though, the trend should be in the other direction, as mortgage rates return to more normal levels. The cut in VAT to 15 per cent implemented in December 2008 and the fall in petrol prices and energy bills are also well on their way to being reversed this year. These factors will contribute to one of the sharpest squeezes on living standards seen since the Second World War.

A recent study for The Independent by PricewaterhouseCoopers suggested that the typical British family faces a decline of at least 2.4 per cent, or £300 a year, in its discretionary spending power, i.e. the amount left over after tax, mortgages, food and other essentials. The best-off will see their spending power cut by as much as 9 per cent, almost £5,000 a year, with the new 50p tax rate, and the most vicious assault on their living standards in three decades.

Many observers believe that the squeeze could be even tighter, as inflation trends higher on the back of soaring global commodity prices. There is an unspoken assumption in City circles that VAT will be increased to 20 per cent, whichever party wins the general election, to help deal with the Budget deficit.

Inflation is already around a quarter of a percentage point higher than the bank thought it would be in November, when the change in VAT was well known. Historically UK inflation has proved "stickier" and harder to control than in comparable economies, and is currently higher than in the eurozone, the US or Japan.