King defends tactics after shock climb in inflation

Governor Mervyn King said inflation will resume its "sharp decline" in the coming months after its rise from 3% in January to 3.2% in February stunned the City and Westminster.

The Governor had to write another letter to Chancellor Alistair Darling explaining why inflation was more than one percentage point above the target. It was his fourth letter since May last year and fifth since he became Governor.

He admitted the Consumer Prices Index was "somewhat higher than expected" but forecast that it would sink below the target of 2% over the next 12 months despite quantitative easing and record low interest rates of 0.5%.

The Bank plans to inject £75 billion of new money into the economy over the next three months to drive spending and support inflation. A further £75 billion could follow but the shock rise in inflation fuelled fears quantitative easing could lead to runaway price rises.

King told MPs on the Treasury Select Committee: "That scenario is never too far down the road not to worry about, which is why it is important that we stick to a clear inflation target. That is the anchor everyone should hang on to.

"We have an exit strategy. The obvious thing to do is to raise interest rates: that we can do at any point. The key anchor for us is the inflation target and that is what guides the exit strategy."

Economists caught out by the rise in inflation — the City was expecting 2.6% — forecast the CPI would fall back below target and even into negative territory despite today's shock. Peter Dixon of Commerzbank said: "I believe this is a one-off spike in inflation which will be reversed in the coming months."

Brian Hilliard, chief UK economist at Société Générale, said: "The key thing is the Bank of England is not going to stop quantitative easing because of this. It has got a long way to go. You would expect the profound weakness in the labour market to bring core inflation down in the next year or so."

The Retail Prices Index, which includes housing costs, fell from 0.1% in January to zero last month on cheaper mortgage rates. Although it did not turn negative as expected, Britain still faces its first bout of deflation in nearly half a century.

"The big picture remains that deflation is imminent for the first time in almost 50 years," said Vicky Redwood of Capital Economics. "After all, at zero in February, the RPI measure was as close to deflation as you can get."

Inflation was higher than expected because of rising food and petrol prices. King also pointed to the dramatic fall in sterling, which has pushed up prices for importers. The pound has lost almost 30% of its value since the summer.

King wrote in today's letter: "Since last summer, world commodity prices have fallen sharply, and that has helped drive a fall in overall CPI inflation from 5.2% in September to 3.2% in February. But the effect on UK consumer prices of decreases in world prices has been dampened by the depreciation of sterling."

He said inflation will fall further on the back of cuts in household gas and electricity bills promised by energy suppliers, which will reduce inflation by around one percentage point in the coming months. He also pointed to the lack of money flowing around the economy and the depth of recession.

"The outlook for global activity will constrain UK demand prospects and, as a result, the margin of spare capacity is likely to build in the coming quarters, pulling down on CPI inflation."

"Consistent with that outlook, wage pressures are muted. As a result of these factors, and not withstanding the inflation out-turn in February, it is likely that over the next year CPI inflation will move below target."

Letters between the Bank of England and the Chancellor explaining the rise in inflation

Letter from Governor to Chancellor (pdf)
Reply from Chancellor to Governor (pdf)