Sean O'Grady: Millions are caught in the new inflation trap

City shocked as weak pound triggers food and petrol price rises, but spectre of deflation remains

The collapse in the value of the pound and a surprising rise in food prices has left inflation stubbornly high, says the Office for National Statistics. The Consumer Prices Index, or CPI, rose last month to an annual rate of 3.2 per cent, from 3 per cent in January.

Indeed, had the Chancellor, Alistair Darling, not cut VAT from 17.5 per cent to 15 per cent in his pre-Budget report last November, the rate would today be standing at an uncomfortably high 4.6 per cent, some way beyond the Bank of England's target of 2 per cent. The higher than expected figure meant that the Governor of the Bank, Mervyn King, had to write his fifth mandatory letter of explanation to the Chancellor.

Mr King blamed much of the "somewhat higher than expected" inflation on the "pass-through" of higher import costs and the depreciation of sterling. The average price of petrol has risen by 3.2p to 89.5p a litre recently, for example.

Yesterday, car manufacturer Ford announced that it would raise its prices by an average of 3.75 per cent, citing the pound-to-euro exchange rate. The company no longer makes any passenger cars in the UK. The pound has lost 28 per cent of its value against foreign currencies over the past 18 months, and is approaching parity with the euro again.

Economists had widely expected that the more familiar and longer-running Retail Price Index, which also takes into account the large reduction in mortgage interest costs since the Bank of England started to cut interest rates last autumn, would turn negative, as world commodity prices pushed it further down.

Instead, it fell marginally, from 0.1 per cent in the year to January to zero during February. Despite the disappointment to expectations, it is still the lowest annual inflation rate recorded since 1960. The RPI is still widely thought to be on track for a negative spell later in the year.

Welcome as such a fall in prices might be on a temporary basis, Mr King has made clear that the Bank wishes to avoid "deflation", a persistent fall in prices across the economy, which tends to become self-fulfilling and is usually accompanied by a collapse in confidence, output and an increase in the real-term burden of mortgage and other debts, depressing the economy. It was last seen in the UK in the 1930s. The Bank of England expects CPI to fall back below the 2 per cent target in the coming months as the impact of lower gas and electricity prices come through and the continuing recession bears down on demand. But the Governor yesterday hinted that he might slow the pace of assistance the Bank is giving to the economy, if the fall in the pound threatens a rapid resurgence of inflation. "The Monetary Policy Committee will need to judge to what extent the main upside risk to the inflation outlook ... is crystallising."

Attention also focused on the disparity between the RPI, which covers housing costs, and the CPI, and what that implies for the living standards of different groups. Over recent months, inflation has hit the older and poorer members of society hardest, as unavoidable costs such as heating and food have risen faster than general inflation, by 22.9 per cent and 11.5 per cent respectively in February.

The biggest winners in the past few months have been homeowners on tracker mortgages, with the fall in bank rate from 5 to 0.5 per cent, an unprecedented reduction, pushing mortgage interest costs 40 per cent lower than last year.

The RPI figures also caused a debate on pay cuts. John Philpott, chief economist at the Chartered Institute of Personnel and Development (CIPD) said: "At least eight in 10 employers use the cost of living benchmark when deciding on staff pay awards. A modest bout of pay depression against a backdrop of zero RPI inflation is good for jobs since it prevents a rise in real pay costs facing firms without hitting people's real standard of living."

But the general secretary of the TUC, Brendan Barber said: "The cost of living is only one factor in wage negotiations, and only those with tracker mortgages have really seen a big impact on their household finances, as the difference between RPI and CPI shows."