Inflation may rise to 5% by the autumn, economists warn

THE latest surge in the cost of living has fuelled fears the annual rate of inflation may peak at 5% by the autumn.

The increase in the Consumer Prices Index (CPI) to 4.4% in July was far greater than the 4.1% or 4.2% forecast in the City and has led economists to warn of worse to come in the next few months.

Further guidance will emerge tomorrow when the Bank of England presents its quarterly projections for inflation and economic growth.

The report will highlight the dilemma facing policymakers, with the Bank's Monetary Policy Committee (MPC) unable to lower interest rates in order to tackle slowing economic growth because of the threat to inflation.

Unemployment and earnings figures are also out tomorrow and will be closely watched for signs higher inflation has filtered through into pay settlements.

Today's figures were driven by a hefty 13.7% increase for food costs, which contributed just under half the 0.6% monthly rise. Within that grouping, bread prices surged 15.9% during the year, meat products by 16.3% and milk, cheese and eggs by 19%, the data showed. Coffee and tea were 5.6% higher.

There were also significant rises for electricity and gas – both running at 12% higher than a year ago – and fuels and lubricants, which surged more than 25% ahead. Energy bills fell this time last year, exacerbating the current rises.

With more firms due to follow recent price hikes from Centrica and EDF Energy, the inflation rate is set to go higher in the coming months.
Today's figures alarmed economists because core inflation, which excludes items that face volatile price movements, rose by more than expected to 1.9%.

Vicky Redwood, of Capital Economics, said she expected CPI to hit 5% in the next two or three months: "The rise in core inflation will clearly leave the MPC concerned that even the sharp slowdown in activity now under way will not be severe enough to prevent a more broad-based pick-up in inflation.

"While we still think that the MPC could cut interest rates before the end of the year, a cut within the next couple of months looks well off the agenda – a message likely to be reinforced in tomorrow's report. Indeed, a rate rise is still a possibility."

Critically, wage growth has so far remained muted, although there are mounting concerns that this can only remain the case for so long.

Wage negotiations are typically based on the headline rate of inflation, the Retail Prices Index (RPI), which leapt to 5.3% last month, up from 4.8% in June.

There are some glimmers of hope, however, as today's figures do not take into account a recent sharp fall in oil prices. The cost of a barrel of oil peaked at 147 US dollars in early July, but retreated to below 120 US dollars a barrel since then.

And producer prices yesterday showed input price inflation for materials and fuels – the costs faced by manufacturers – fell between June and July to 30.1%, the first dip in 12 months.

However, factory gate prices still showed factory bosses charged a double-digit annual percentage rise in the cost of their goods.

David Kern, economic adviser to the British Chambers of Commerce, said falling oil prices and lower input prices meant he expected CPI inflation to reach its peak within the next two or three months.

He added: "The threats of recession are worsening. Although it is difficult for the MPC to consider rate cuts while inflation is still rising, it should not hesitate to cut rates later in the autumn once it is clear inflation has peaked."

Economists are unanimous in their view that the spike in inflation is just that, with the view that inflation will sharply pull back amid the economic slowdown.

The Bank of England may, in fact, face the headache of inflation undershooting its 2% target in two years' time if it takes too aggressive action now or if the economy slows too much.

Most economists expect the Bank to keep rates at 5%, with the economic decline dragging inflation lower next year and paving the way for "aggressive" rate cuts in the first half of 2009.