UK January Inflation: Economists' Reaction

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Tuesday, official figures released by the Office for National Statistics showed that U.K. inflation surged in January.

Annual inflation rose to 3.5% in January from 2.9% in December, matching economists' expectations. The rate was the highest since November 2008. Increase in VAT rate leads to record CPI monthly movement for the December to January period, the ONS said. Month-on-month, the consumer price index fell 0.2% in January, while economists expected it to fall 0.1%.

As annual inflation exceeded 3%, Bank of England Governor will write an open letter to the Chancellor explaining the reasons why inflation has increased to such an extent and what the Bank proposes to do to ensure inflation comes back to the target. The central bank is set to publish Governor's Letter at 5.30 am EST.

Retail prices remained flat between December and January, in line with expectations. At the same time, the RPI annual inflation rate increased to 3.7% in January from 2.4% in December. Excluding mortgage interest payments, retail prices were up 4.6% in January, up from 3.8% in

Economists' Reaction:

ING Bank NV's James Knightley expects the central bank to argue that inflation should fall again soon as the economic recovery remains fragile and fiscal policy is set to continue being tightened. The central bank downwardly revised its growth forecast last week.

The economist pointed out the huge amount of spare capacity in the U.K. economy that has left wages barely rising. According to him, this should ensure that inflation gradually falls 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.

"We reiterate that in a weak growth, tight fiscal policy environment, it will be loose monetary policy that will be the release valve," the ING economist. He expects interest rates to remain at ultra low levels for a prolonged period and eventually rise to 1% in the fourth quarter of this year and 2.75% in the final quarter of 2011. "This will help to keep sterling relatively weak on a trade weighted basis."

Capital Economics' Jonathan Loynes said latest consumer prices figures should help to reassure the Monetary Policy Committee that the recent rise in inflation will prove to be only temporary. The economist sought attention to core inflation that excludes food and energy. Core inflation rose only from 2.8% to 3.1%, which according to Loynes signal that retailers offset much of the VAT effect. However, the CPIY, which strips out the effects of indirect taxes, dropped sharply from 2.8% to 1.9%, he pointed out.

"This might be a timing effect - retailers may have already raised prices in anticipation of the hike or will do so further in the next month or two," Loynes said. "But it might also be the first sign that the vast amount of spare capacity in the economy is starting to weigh down on underlying price pressures."

"Inflation fears are not about to evaporate altogether, but there is nothing here to panic the MPC into a premature tightening of policy conditions," the economist said.

(Market News Provided by RTTNews)