Inflation threat makes rates rise likely

The central bank left borrowing costs on hold at 0.5 per cent this month, even though an estimate for January due today is likely to have shown that consumer prices inflation climbed to 4 per cent – double its 2 per cent target.

This would force Mervyn King, Governor of the Bank of England, to write another letter to Chancellor George Osborne explaining the overshoot.

Investors reckon the central bank may have to start tightening policy sooner rather than later to bring inflation back on track, and money markets are almost fully pricing in a 25 basis point rise in borrowing costs by May.

Most city economists do not expect the central bank to start tightening policy until much later this year, however, highlighting the dilemma facing policymakers of how to tackle rising price pressures without derailing the economic recovery.

“Our forecast is for August, but I think there’s wiggle room in both directions, and May is looking increasingly likely,” said Alan Clarke, economist at BNP Paribas.

Inflation at the end of last year already exceeded the Bank’s November Inflation Report forecasts, averaging 3.4 per cent, and Mr King warned in January that surging oil and commodity prices could drive CPI up to almost 5 per cent.

The Bank produces two forecasts for inflation – one based on market interest rate expectations and one that assumes interest rates remain at 0.5 per cent.

Analysts reckon that near-term inflation forecasts on both measures will be revised upwards to reflect a greater knock-on impact of rising commodity prices and value-added tax.