VAT change sends inflation soaring

Last month's reversal in the VAT reduction saw inflation leap to 3.5% in January - its highest level since November 2008, official figures revealed today.

The Office for National Statistics (ONS) said the rise in Consumer Prices Index (CPI) inflation came as the cost of alcohol, tobacco, hotels and restaurants soared after the Government raised VAT tax back up to 17.5%.

The 14-month CPI high triggers an open letter from the Governor of the Bank of England Mervyn King to the Chancellor to explain why inflation is more than 1% above the 2% target.

Today's CPI hike comes after an all-time record rise in the rate of inflation in December, when inflation surged to 2.9% from 1.9% in November.

But the January increase was in line with expectations and the Bank's own forecast.

The Bank indicated last week that it expected CPI to peak at 3.5% before falling back below 2% later this year.

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

The Government reduced VAT to 15% 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% 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% between December and January - traditionally a time when prices fall.

It was the smallest ever 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%.

Last month's adverse weather also impacted 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% from 2.4%.

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.

The Bank's quarterly forecast last week signalled that it would fall due to the economic slack created by the recession, even with rates kept at the all time historic low of 0.5% and with its £200 billion Quantitative Easing programme left in place.

Minutes due tomorrow of the Bank's last rates meeting could show a split over the decision to pause QE, given the weak recovery in the economy.

Six quarters of decline came to an end in the final three months of 2009 with an upturn of a meagre 0.1% and the Bank has since reduced its growth forecasts.

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% to 3.1%, 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."