King Warns Inflation to Reach 4% by Year-end

Mervyn King, the BoE's governor, has been forced to exchange letters with the chancellor on Tuesday explaining how he plans to restore price stability, after official data showed UK consumer price inflation rose to 3.3 per cent in May.

In a letter that the City regarded as showing the Bank was willing to accommodate inflation well above target inflation for an extended period, Mr King blamed higher inflation on development in the global balance of demand and supply of food and energy”.

The Bank predicted in May that inflation would rise to around 3.5 per cent. But Mr King now writes: As things stand, inflation is likely to rise sharply in the second half of the year to above 4 per cent”.

But the Bank sought to avoid any blame for higher inflation, insisting there is not a generalised rise in prices and wages caused by rapid growth in the amount of money spent in the economy.”

It expects overall spending growth to be relatively constant, so the higher inflation it expects will go hand-in-hand with a squeeze on households’ living standards.

Mr King said he hoped to get inflation back down to the 2 per cent target in around two years time, as the decline in income growth, the economic slowdown and expected rises in unemployment gradually squeeze inflation out of the system.

There were no hints about what the Bank will do with interest rates, but markets responded to the Bank’s letter by reducing expectations of interest rate rises, seeing the Bank as more willing to accommodate higher inflation and risk inflation becoming ingrained into normal life than investors expected.

The letters came after the Office for National Statistics said the annual rate of inflation on the consumer price index the Bank targets rose from 3 per cent in April to 3.3 per cent in May – the highest it has been since the Bank was given independence in 1997.

Analysts had expected a jump to 3.2 per cent after the relentless rise in oil prices, which is driving up petrol and utility bills and exacerbating factory gate inflation.

The ONS said the biggest upward effect on inflation came from gas and electricity bills that remained constant when they had fallen in the same month of 2007, and from higher food prices – especially for meat and fresh vegetables.

Annual food price inflation picked up from 6.6 per cent to 7.8 per cent, the highest since records began in 1997. More worrying for policymakers, though, will be the fact that no area is free of price pressures, despite Mr King’s focus only on inflation driven by global commodity price rises.

Higher goods prices drove the rise in the headline rate, but prices for services have also risen 3.8 per cent in the last year. Core” inflation – excluding food, energy and other more volatile items – also edged up from 1.4 per cent to 1.5 per cent in May.

King Warns Inflation to Reach 4% by Year-end, Bloomberg
6/17/2008 6:07:07 AM