Record inflation jump puts BoE under pressure to increase rates

CPI rises to 2.9 per cent after temporary VAT cut stimulates spending

The Bank of England's Monetary Policy Committee (MPC) may be forced to increase interest rates faster than it, or the Government, had expected after yesterday's inflation numbers showed that prices had risen further than analysts had forecast.

The Consumer Price Index (CPI) rose to an annual rate of 2.9 per cent in December, up from 1.9 per cent in November, the Office for National Statistics (ONS) said. This monthly jump is the biggest since records began.

The Retail Price Index, which includes housing costs, soared from an annual 0.3 per cent in November to 2.4 per cent last month, the biggest month-on-month rise in the annual RPI rate for 31 years.

The Government has been desperately trying to encourage spending in the economy to stave off a lasting recession. Measures such as lowering the VAT rate last year and the car scrappage scheme were introduced to boost consumer activity, but the worry will now be that the policies may have gone too far. The ONS figures are also likely to play into the MPC's decision next month on whether to extend its £200bn quantitative easing programme.

While the economy is officially expected to emerge from recession next Tuesday, when the ONS publishes GDP figures for the fourth quarter of 2009, Mervyn King, the Bank's Governor, and the other members of the MPC also now face the challenge of controlling rising prices. Speaking at Exeter University last night, Dr King warned that "the rise in VAT back to 17.5 per cent means that CPI inflation is likely to rise to over 3 per cent for a while, or even higher for even longer were energy prices or indirect taxes to increase further".

The MPC is charged with keeping inflation at the Government's 2 per cent target. If it is missed by a 1 percentage point either side, Dr King must explain why in a letter to the Chancellor.

Yesterday's inflation figures led to a number of economists pointing out that the MPC is likely to consider interest-rate rises at its February meeting. The base rate has been kept at a record low of 0.5 per cent since March last year.

"The Governor will be able to explain the January move in CPI inflation above 3 per cent as the result of the VAT reversal," said Simon Ward, the chief economist at fund managers Henderson. "The persistent and significant divergence of core inflation from the 2 per cent target, however, is more troubling and casts doubt on the sustainability of the current policy stance."

Others argue that any recovery will be sluggish thanks to persistently high unemployment and expected cuts in public spending later this year.

"[Yesterday's] data will raise fears that the spare capacity in the economy will not tame inflation," said Colin Ellis, an economist at Daiwa Securities. "But the key policy mistake the MPC made in 2008... was to be too slow in cutting rates in response to the onset of recession. As such, although CPI inflation could well breach 3 per cent at the start of 2010... that is not a good reason for the MPC to start tightening policy."

The Governor: 'Slow wage recovery'

British households will be "sorely tried" as the country battles its way out of recession, with workers' pay demands falling on deaf ears despite a return to both economic growth and inflation, the Governor of the Bank of England warned last night.

In a speech at the University of Exeter, Mervyn King said that "the patience of UK households is likely to be sorely tried over the next couple of years. There is little scope for growth in real take-home pay, which remains weak even as output recovers." He added it was too early to tell if the corrective measures meted out to the UK economy, including the Bank's £200bn quantitative easing (QE) programme, have solved problems caused by the banking crisis and the subsequent recession.

Dr King also called on the G20 group of most developed countries to cut imbalances in the global economy. "Concrete steps to reduce the scale of global imbalances have, to date, been notable by their absence. Smiling family photographs marking the attendance at international gatherings are no substitute for specific action."

2.1

Percentage-point rise in Retail Price Index between November and December, the biggest monthly rise for 31 years.