Surprise rise in inflation defies City predictions• CPI rises to...

Surprise rise in inflation defies City predictions• CPI rises to 3.2% in February
• King predicts 'sharp decline' soon as utility costs fall
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The headline rate of inflation proved surprisingly resilient last month because of higher than expected food and alcohol prices – confounding expectations among City economists of a fall.

The government's preferred measure of inflation, the consumer prices index (CPI), rose to an annual rate of 3.2% in February from 3% the month before, according to figures from the Office for National Statistics. Economists had expected it to drop to 2.6%.

Higher food prices, in particular meat and vegetables, alongside soft drinks and alcohol, were responsible as the weaker pound and a poor crop in Spain made some imported products more expensive. Alcohol prices are now rising at the fastest rate since 1992.

Sterling hit a six-week high against the dollar after the numbers were released. It rose by more than half a cent to $1.4778.

The unexpected rise in inflation forced Bank of England governor Mervyn King to write his fourth letter to the chancellor to explain why the rate had strayed more than a percentage point from the central bank's 2% target.

He warned, however, that inflation would fall by "around a percentage point" in coming months because the major gas and electricity suppliers had reduced their prices, and the economy would continue to weaken. He added that it was likely that inflation would move below the 2% target over the next 12 months but cautioned that the path of inflation could remain "volatile".

City experts agreed with the governor. James Knightley at ING said: "Utility tariff cuts will be feeding through very strongly from the March report onwards while weaker economic activity will also constrain corporate pricing power and help to drive inflation lower in coming months."

In comments to the Treasury select committee, King admitted that today's inflation figures were higher than he and his colleagues on the monetary policy committee had expected. He said: "With a 28% fall in the exchange rate over 18 months, we clearly expected a good part of that to feed through to the domestic price level. What was unclear was precisely how much and at what speed it would come through." He also added: "I see no reason why [sterling] should go any lower."

King also told the parliamentary committee that the Bank could spend less than the planned £75bn on buying up government bonds if the quantitative easing programme succeeded in unfreezing credit markets. The June gilt future tumbled by more than two full points to a three-week low of 120.70 on the comments.

The ONS data also showed that the retail prices index (RPI) – the broadest measure of inflation, which includes mortgage payments and housing costs – slipped to an annual rate of 0% last month, defying widespread expectations of a decline into negative territory, or deflation.

It was the weakest reading since March 1960, the last time Britain suffered a period of price deflation.

Economists think RPI inflation could still drop as low as -4% later this year as tumbling interest rates, mortgage costs and the reduction in energy bills feed through.

Philip Shaw, chief economist at Investec, said: "RPI inflation is stubbornly avoiding going into negative territory, but we think it's only a matter of time before it does."

If the RPI turns negative in coming months as expected, many workers will suffer because the index is used as a benchmark in wage negotiations.

A number of companies have already imposed pay freezes and some have even reduced pay. Workers at Honda's car plant in Swindon were told yesterday they would have to take a one-year pay cut (likely to be 10%), while Vodafone confirmed it was freezing the salaries of its 10,000 UK staff and would probably scrap bonuses.

As falling earnings prompt a sharp decline in consumer spending, a prolonged period of deflation could push Britain's economy into the kind of stagnation suffered by Japan in the 1990s and into this century.

Underlining the severity of the economic situation, the Bank's labour market expert, David Blanchflower, warned today that the unemployment rate – currently at 6.5% – could be in double figures by the end of the year.

Pensions and state benefits are also calculated on the basis of RPI, although pensioners will not suffer as much as feared, at least not for a while. Each spring, the state pension is raised in line with RPI from the previous September. This year pensioners will benefit from the fact that RPI hit a record high of 5% last September driven by surging oil prices.

The government has also pledged not to reduce any state benefits, which will be raised by 5% on 6 April.

The gap between the two measures of inflation is the biggest since records began in 1989, as aggressive interest rate cuts have pushed RPI sharply lower, while CPI excludes mortgage and housing costs.
Julia Kollewe
guardian.co.uk, Tuesday 24 March 2009 12.54 GMT
http://www.guardian.co.uk/business/2009/mar/24/rpi-inflation-zero