Shock rise in inflation risks higher rates and unemployment

Latest figures raise fears that interest may go up at the same time as fiscal cuts start to bite into economy

Retail price inflation soared to a near-20 year high of 5.3 per cent in April, from 4.4 per cent in March, according to the Office for National Statistics (ONS). Such a shocking figure – way higher than City estimates – has worrying implications for pay bargaining this year and future inflation and employment prospects, as the RPI measure is traditionally used for wage bargaining. It stands at its highest since July 1991.

Wage restraint, including widespread freezes, has been widely credited with keeping unemployment below the levels that might have been expected, given the severity of the fall in output. That may now be jeopardised by these figures. It also suggests that consumer spending will be more depressed in future, or that households will cut savings or pension contributions to maintain current living standards. Yesterday the ONS also reported a decline of £1bn a year in personal pension contributions.

On the Consumer Price Index measure, the figure monitored by the Bank of England and which excludes housing costs, the annual rate of inflation reached 3.7 per cent last month, up from 3.4 in March, a 17 month high. It was 1.1 per cent as recently as last September.

The Governor of the Bank of England, Mervyn King, was forced to write an open letter of explanation to the new Chancellor, George Osborne, to explain the Monetary Policy Committee's (MPC's) failure to keep inflation within 1 per cent of the 2 per cent official target. In his letter, Mr King stated that the rise in inflation was due to three essentially temporary factors.

The Governor pointed to an 80 per cent rise in oil prices since last year, the restoration of VAT to 17.5 per cent on 1 January, and the sharp depreciation of sterling over 2007 and 2008 as key factors in pushing inflation higher.

Mr King said that these factors "more than accounted for" the deviation of inflation from the target. A year ago, in its May 2009 Inflation Report, the Bank predicted that inflation now would be about 0.7 per cent.

In his letter to Mr Osborne, Mr King admitted that "inflation has been somewhat higher than expected over the past year and the Committee is conscious that the pace and extent of the prospective fall in inflation are highly uncertain".

In his response, the Chancellor told the MPC to be "vigilant" and asked Mr King for his views on "how we might accelerate the process of including housing costs in the CPI inflation target". Mr King is on the record as supporting such a move. It was also called for in opposition by the new Business Secretary, Vince Cable.

The ONS said the rise in inflation was broadly based, though increases in the cost of women's clothing, food, mobile phone charges and car insurance stood out. Alcohol and tobacco prices also rose after hikes in excise duty. The RPI was also driven higher because the reductions in mortgage bills – not included in the CPI – seen last year are not being repeated this year, as the Bank has left the Bank Rate at 0.5 per cent for more than a year.

Economists have expressed concern about the persistent tendency for UK inflation to overshoot consensus and official forecasts. Underlying inflation – stripping out seasonal food and other volatile items – stands at 3.1 per cent, the highest since at least 1997, when this measure was first tracked. Pulling inflation back was a relatively modest rise in council tax, up 1.7 per cent against a rise of 2.7 per cent in last year's bills.

Jonathan Loynes, the chief european economist at Capital Economics, said: "The data will fuel fears that the MPC might have to raise interest rates to quash price pressures just when the fiscal squeeze is about to hit the economy, too."