Inflation rises unexpectedly

LONDON Tue Mar 24, 2009 6:51pm GMT

People shop for groceries at a store in High Wycombe, January 23, 2009. REUTERS/Eddie Keogh

People shop for groceries at a store in High Wycombe, January 23, 2009.

Credit: Reuters/Eddie Keogh

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LONDON (Reuters) - Soaring food prices and a weaker pound pushed inflation well above its 2 percent target last month, but the Bank of England said price growth would still slow sharply as the economic downturn saps demand.

Government bonds dived and sterling shot up Tuesday after the Office for National Statistics said consumer price inflation rose to 3.2 percent in February, despite a recession that has pushed the BoE to adopt unprecedented measures to boost growth.

Inflation was much stronger than even the highest forecast in a Reuters survey and forced King to explain himself to the government, as required by the BoE's mandate when inflation deviates from its 2 percent target by more than a percentage point.

The weakness of sterling was probably to blame, King said. Food and non-alcoholic drink prices were the single biggest driver of the inflation jump. Other sectors depending on imported goods also had an upward effect.

King said policymakers would have to see whether this meant that the upside risks to their forecasts were now coming true, but this still did not mean there was much danger of inflation being meaningfully above target in the medium-term.

"With a 28 percent fall in the exchange rate over 18 months, we clearly expected a good part of that to feed through the domestic price level," King told a parliamentary committee.

"But of course the big picture offsetting, the big downward pressure on inflation, is the degree of spare capacity that has built up."

Analysts by and large agreed. "It doesn't shake our belief that inflation will head significantly below target in the coming months," said Philip Shaw, chief economist at Investec.

The RPI measure of inflation, on which many wage deals are based and includes housing costs and mortgage interest payments, fell to zero in February, the lowest rate since 1960, and analysts expect this to be negative for months ahead.

SHRINKING ECONOMY

The British economy went into recession last year and shrank by 1.5 percent in the last three months of 2008 alone, the sharpest contraction in nearly three decades.

King hinted that first quarter-figures could be as bad or worse given the state of the world economy, his biggest concern.

The BoE has already cut interest rates to a record low of 0.5 percent from 5 percent in October and embarked on a 75 billion pound asset-buying program -- printing money by any other name -- to boost the credit-starved economy.

But gilt prices, already hammered by the rise in inflation, plummeted further after the governor suggested the BoE might not have to use the full 75 billion pounds quantitative easing (QE) program. The June future was at one stage down more than 2 full points.

Later in the day, King told the House of Lords that the BoE would have to be ready to raise rates fast to avoid inflation once growth started to recover.

"It's a double whammy of unexpected quickening of inflation and the product of King's comment that the bank may not need to purchase as many gilts as planned should the QE process seem to be working," said Richard McGuire, fixed income strategist at RBC Capital Markets.

Sterling also rose further after its inflation-inspired jump after King said he saw no reason for sterling to fall any further but that its decline so far had been part of a necessary rebalancing of the British economy.

The governor also had a warning for Chancellor Alistair Darling ahead of the April 22 budget in case he was planning more fiscal stimulus to help the recession-hit economy.

"I'm sure the government will want to be cautious in this respect. There is no doubt we are facing very large fiscal deficits over the next 2-3 years," he said.

"The level of the fiscal position in the UK is not one that would say: 'Well, why don't we just engage in another significant round of fiscal expansion?'"

(Additional reporting by David Milliken, Keith Weir, Luke Baker, Kate Kelland, Peter Griffiths and Frank Prenesti)

(Writing by Sumeet Desai and David Milliken, editing by Stephen Nisbet and Andy Bruce)

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