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U.K. annual inflation for January accelerated to the highest since November 2008 and exceeded the 2% target again, forcing the central bank governor to write an open letter to the Chancellor explaining why the measure increased to such an extent.
Consumer price annual inflation rose to 3.5% in January from 2.9% in December, the Office for National Statistics reported Tuesday. The annual rate matched economists' expectations and was the highest since November 2008.
Increase in the value added tax rate led to record monthly movement in the consumer price index for a December to January period, the ONS said. Month-on-month, the CPI fell 0.2% in January, while economists expected it to fall 0.1%. Although negative, January's figure was the strongest ever CPI growth between these two months.
The largest upward contribution to the change in the CPI annual rate came from transport, recreation and culture, alcohol, beverages and tobacco and housing and household services. Meanwhile, the only large downward contribution to the CPI annual rate came from clothing and footwear.
Capital Economics' Jonathan Loynes said the latest CPI figures should help to reassure the MPC that the recent rise in inflation will prove to be only temporary. "Inflation fears are not about to evaporate altogether, but there is nothing here to panic the MPC into a premature tightening of policy conditions."
In the quarterly Inflation Report released on February 10, the BoE said the inflation is set to undershoot its 2% target. Inflation will peak at around 3.3% before slowing to 0.9%. The central bank also downgraded the economic growth forecast to around 3.2% in the second quarter of next year from the previous estimate of 4%.
Core inflation that strips out energy, food, alcohol and tobacco came in at 3.1% on a yearly basis, following December's 2.8%. Consensus forecast was for 3.2%.
Retail prices remained flat between December and January, in line with expectations. The retail price index fell slightly to 217.9 from 218 in December.
At the same time, the RPI annual inflation rate increased to 3.7% in January from 2.4% in December. However, the annual rate stood slightly below the consensus forecast of 3.8%. The ONS data showed that RPI annual inflation is higher than consumer price inflation for the first month since August 2008. Excluding mortgage interest payments, retail prices were up 4.6% in January, in line with expectations, but below December's 3.8%.
As annual inflation exceeded the 2% target by one full percentage point, Bank of England Governor Mervyn King wrote an open letter to the Chancellor. In his letter, King said three short-run factors raised the current measured rate of inflation. The restoration of the VAT to 17.5% and about 70% increase in oil prices pushed inflation higher. Further, the effects of a sharp depreciation of sterling in 2007 and 2008 continued to feed through to consumer prices.
The Monetary Policy Committee expects deviation in inflation from the target as temporary, King said. The direct effect of these short-run factors on inflation should be only temporary. Thereafter, inflation will be determined by the growth rate of nominal spending relative to the supply capacity of the economy.
The central bank chief pointed out that weakness in spending in the previous year created a substantial margin of spare capacity within the economy. The MPC expects it to bear down on inflationary pressure over time. The low level of Bank Rate and the effect of money-financed asset purchases will continue to provide a substantial boost to nominal spending for some time to come.
According to ING Bank NV's James Knightley, a huge amount of spare capacity in the economy left wages barely rising. This would ensure than inflation will fall back towards the 2% target later this year. However, inflation may prove to be somewhat stickier given the talk of additional increases in the value added tax post the upcoming election, Knightley cautioned.
"The Committee is committed to taking whatever actions are necessary to ensure that the outlook is for inflation to remain in line with the 2% target," King said. Further, he said if the medium-term outlook for inflation threatened to rise above the 2% target in future, the Committee would tighten monetary policy. The central bank will continue to watch the appropriate scale of the asset purchase programme and further purchases would be made should the outlook warrant them.
In his response, Chancellor Alistair Darling noted that the inflation outlook remains subject to some uncertainty with the world economy emerging from the deepest downturn in modern times. Darling expects growth to pick up through 2010 and 2011. He said the government will continue to support the MPC in the forward-looking decisions it takes, consistent with the monetary policy objectives set out in the remit.
ING's Knightley expects interest rates to remain at ultra low levels for a prolonged period and eventually rise to 1% in the fourth quarter of 2010 and 2.75% in the fourth quarter of 2011.
On February 4, the MPC had halted its GBP 200 billion bond purchase programme and kept its door open for further purchases, provided the outlook warrant them. Policy makers had also voted to retain the key interest rate at a record low 0.5%.
Tullia Bucco, an economist at UniCredit Research, noted that BoE's future moves remain very much data-dependent, given the lingering uncertainty about the pace of the recovery and the amount of slack in the economy. As such, the central bank is expected to raise the repo rate to 1% just before the end of the year.
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