Inflation Rise in UK beats Analysts Expectations

Price rise pressure on Bank of England

Investors betting on summer rates increase

Consumer index lift higher than expected

By Daniel Pimlott and Chris Giles in London

Investors are betting that the Bank of England will start raising interest rates in early summer after soaring fuel and food prices pushed inflation higher than expected in December.

The UK consumer price index rose 3.7 per cent in the year to December, with inflation up from 3.3 per cent in November. The latest nasty surprise on prices led some economists to predict that inflation will reach 5 per cent, more than double the Bank’s 2 per cent target.

The spike in inflation squeezes household and corporate incomes, putting a further brake on the recovery at the same time as austerity begins to bite. It also threatens to become ingrained in people’s expectations, making it more difficult to eradicate.

Investors are now betting that the Bank’s monetary policy committee will soon feel the need to show it is serious about beating inflation and will raise interest rates from their current low of 0.5 per cent.

The high level of inflation – reflecting the 25 per cent fall in sterling since 2007 – gives the Bank an even worse dilemma than European Central Bank, which put down a marker against price rises last week after inflation in the eurozone rose to 2.2 per cent.

In Britain, the Bank is coming under fire, partly for failing to foresee the rise in inflation. As recently as February, it forecast that inflation would be only 1.5 per cent in the fourth quarter of 2010 and thought that the chances of the 3.4 per cent outcome were negligible.

Ben Broadbent, an economist at Goldman Sachs, calculated that after adjusting for the unexpected value added tax cut of 2009, “the MPC has under-predicted inflation in every year since the CPI target was introduced in 2004”.

Michael Saunders, an economist at Citi, who has repeatedly warned of the Bank’s overoptimism on inflation, said the MPC faced a crisis of inflation forecasting and credibility.

“The MPC needs to show . . . that it takes the inflation target seriously, which means tough rhetoric near term and then probably also higher policy rates in coming months,” he added.

The Bank argues that such price increases are temporary. It suggests that inflation is going to fall next year once the rise in VAT falls out of the annual comparison and spare capacity in manufacturing and services discourages companies from raising prices.

“We have to look through those short-term things, despite whatever unpopularity comes our way,” Paul Fisher, head of markets at the Bank and a member of the MPC, said in an interview with a regional newspaper.

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