Bank 'surprised' at inflation strength

Bank of England Governor Mervyn King today said rate-setters had been "surprised" at the recent strength of inflation and warned it would be difficult to judge how far and fast it would fall.

The comments came in his open letter to Chancellor George Osborne as inflation edged down from 3.2% to 3.1% in July, but remained stuck well above the Bank's 2% target.

Rising food costs offset the impact of falling petrol prices over the month on the Consumer Prices Index (CPI), which the Bank expects to stay above target until the end of next year.

The Governor said: "How fast and how far inflation will fall are both difficult to judge. with substantial risks in both directions."

The Bank, which has faced criticism over its forecasting in recent weeks, lowered growth predictions in its quarterly report last week and said inflation would be higher than first thought.

The Governor said the huge economic slack created by a record recession was being masked by January's VAT hike, high oil prices and sterling's weakness pushing up import prices. The looming VAT hike next year will add to inflation pressure.

He also underlined his warnings of a "muted" recovery not strong enough to close the gap created by the slump, eventually dragging inflation below the target.

But there was better news for the Bank's inflation-watchers after 'core' CPI - which excludes volatile elements such as food, energy and alcohol prices - fell from 3.1% to 2.6%, the lowest level since November 2009. Stripping out the impact of indirect taxes such as VAT, CPI has slowed to just 1.4%.

Jonathan Loynes, chief European economist with Capital Economics, said: "The fact that core price pressures are clearly weakening for now should help to ease concerns that high inflation has somehow become ingrained in the economy or that the MPC is deliberately turning a blind eye to persistent price pressures.

He added that a majority of the bank's rate-setting committee were "likely to remain comfortable" with record low interest rates to boost the economy for some time to come.

Andrew Goodwin, senior economic advisor to the Ernst & Young ITEM Club, added: "Earnings growth remains below 2% and it is difficult to make a case for inflation taking off without a response from wages - in the current climate, with unemployment remaining high and public sector job losses on the way, the scope for workers to push up wages is very limited."

The Office for National Statistics figures showed a 0.7% jump in food prices between June and July - the biggest monthly rise for two years - driven by higher costs for meat, fruit and vegetables contrasted with price falls a year earlier.

The annual rate of food inflation rose to 3% over the month - the highest for a year - while the Russian drought and rising wheat prices is set to build food inflation in the months ahead.

But falling petrol costs and second-hand car prices over the month dragged down the overall CPI, as motorists enjoyed an average 0.7p a litre drop over the month against a 1.1p hit at the forecourt a year earlier.

The squeeze on food shopping bills also contrasted with the picture on the high street, where retailers are still cutting prices in a bid to draw in worried consumers.

The ONS said clothing and footwear prices fell 4.9% between June and July, led by womenswear. This is the biggest price slide in a single month since 2002.

But rail commuters meanwhile will be braced for fare rises of almost 6% next January despite the Retail Prices Index (RPI) easing to 4.8% in July. Most regulated rail fare increases are based on a formula of July's RPI plus 1% - which would leave passengers facing rises of 5.8%.

Andrew Tyrie, the Tory chairman of the Commons Treasury Select Committee, said the situation had to be monitored to ensure inflation did not become entrenched.

He told BBC Radio 4's The World at One: "What I think we have got to do is monitor this extremely carefully and bear in mind that we cannot afford to take risks with inflation while at the same time recognising monetary policy is very loose, it needs to stay loose.

"We have got interest rates at 0.5%, the Governor is making clear that they have got to stay there until we make sure that we have got a recovery deeply entrenched."