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Oil prices and tax cuts fuel inflation leap

THE annual rate of inflation accelerated in December at record pace, raising concerns that the Bank of England may feel compelled to raise interest rates sooner than expected.

The consumer prices index on an annual basis jumped one per cent in December to 2.9 per cent, fuelled by a jump in oil prices compared to December 2008 and as the VAT cut dropped out of the comparison.

This is the first time since May that the annual rate has exceeded the Bank of England’s two per cent target and economists are forecasting for it to accelerate further in the coming months. Inflation is already just below the three per cent level that would require a letter from Bank governor Mervyn King to the chancellor.

Michael Saunders, UK economist at Citigroup, said: “CPI inflation is likely to rise into letter-writing territory above three per cent in the January data as the VAT hike starts to come through. We expect CPI inflation to average close to four per cent this year, probably staying above three per cent to mid-2010 at least.”

The Bank of England had expected inflation to rise sharply in the first quarter and has resolutely maintained that it would look through the spike, but the unexpected pace suggests that the problem may be more acute than previously thought.

RBC Capital Markets’ Richard McGuire said: “Although the Bank will continue to look to the considerable slack that has opened up in the economy as justifying its view the current inflation spike will prove a transitory affair, today’s numbers make a compelling case for, at the very least, taking a breather as regards quantitative easing come 4 February.”

In the face of rapidly rising inflation, there are concerns that the Bank of England’s loose policy could undermine its credibility. The Bank has justified its loose monetary policy on the basis that inflation would fall back below the two per cent target in the medium-term.

With such an undershoot now unlikely, Henderson’s Simon Ward said this implies “that the MPC must advance its timetable for tightening if a destabilising rise in inflationary expectations is to be avoided.”

The retail prices index (RPI), shot up to 2.4 per cent from a meagre 0.3 per cent in November.