Higher than expected UK inflation prompts warning over interest rate hike

News - Banking

Written by Ray Clancy

Wednesday, 20 January 2010 09:44

Higher than expected inflation in the UK could result in higher interest rates within months with even the governor of the Bank of England admitting that inflation is likely to rise to 3% and over.

Figures released yesterday by the Office of National Statistics showed that Consumer Price Inflation jumped in December to 2.9%, higher than the expected 2.6%. It is the first time since May that inflation has exceeded the bank’s 2% target rate.

The inflation rate rose after oil prices jumped and 2008 cuts in sales tax and retail prices weren’t extended into 2010. The news prompted a number of economists to warn that interest rate rises are now inevitable.

Mervyn King, the governor of the Bank of England, last night said a further rise in inflation is expected. ‘It is clear that inflation is likely to pick up markedly in the first half of this year. The rise in VAT back to 17.5% means that inflation is likely to rise to over 3% for a while, or even higher for even longer were energy prices or indirect taxes to increase further,’ he said in a speech last night at Exeter university.

‘Although such price level effects do not constitute a continuing source of inflation, and hence should be temporary, they remain in the official measure of inflation for a full year.
Provided monetary growth remains well under control, and remember that at present it is undesirably low, inflation should return to target in the medium term,’ he added.

But his words were not sufficient comfort for many analysts. ‘The speed of the increase is something that will be worrying the Bank of England as it creeps higher. I think that we will see a vote for an interest rate increase from some of the more hawkish members of the Monetary Policy Commitee in the next two months, with rates actually rising in the third quarter,’ said Jeremy Cook, chief economist of foreign exchange broker World First.

Nick Kounis, an economist at Fortis Bank, also believes interest rates will rise sooner rather than later. ‘The Bank of England will be the first major central bank to hike interest rates and we expect them to do so in May,’ he said.

Howard Archer, chief UK and European Economist at IHS Global Insight, described the data as a nasty shock. ‘While the Bank of England has been expecting inflation to spike up, December’s increase was clearly way more than the bank expected,’ he said.

‘The December inflation data not only makes it even more likely that the Bank of England will call a halt to its Quantitative Easing programme at its February meeting, but also increase the risk that the central bank could start raising interest rates well before the end of 2010,’ he added.

Azad Zangana, European Economist at Schroders, said he believes that next month’s inflation figure, which will include the full impact of VAT being re-instated at 17.5%, will rise above 3%. But he does not think an immediate interest rate rise is inevitable. ‘We do not expect the Bank to panic and raise rates. This should spell the end of quantitative easing in February, but worries over growth and rising unemployment will keep the monetary policy committee in wait and see mode for some time,’ he explained.

The Pound rallied strongly against both the Euro and the US Dollar as a result of the news but many believe that the UK currency may fail to consolidate after King somewhat gloomy speech at Exeter. King also said that the full impact of the financial crisis has yet to be seen.