August 17, 2010 / 7:02 AM / 10 years ago

Inflation slows as Bank's King defends overshoot

LONDON (Reuters) - British inflation slowed in July as expected but stayed far above the 2 percent target, forcing Bank of England Governor Mervyn King to explain the overshoot in an open letter to the government for the third time this year.

A woman walks past a Waterstone's book shop in London January 14, 2010. REUTERS/Suzanne Plunkett

The Office for National Statistics said the annual CPI rate eased to 3.1 percent from June’s 3.2 percent — the lowest since February but the eighth consecutive month that it has exceeded the Bank’s 2 percent target.

In his letter, King said he still expected inflation to fall below target in two years and blamed the persistent above-target readings on one-off factors, suggesting the central bank is in no hurry to raise interest rates anytime soon.

Nor does the government look too concerned.

Chancellor George Osborne, conscious the economy needs all the support it can get over the next few years as he tries to bring down a record budget deficit, replied to King that the Bank’s remit allowed it it look through short-term inflation moves.

Osborne, in a speech later on Tuesday in London, also hit back at accusations his planned spending cuts will plunge the economy back into recession and said there were reasons to be cautiously optimistic about the future.

“The gamble would have been not to act, to put Britain’s reputation at risk, and to leave the stability of the economy to the vagaries of the bond market,” he said.

But he admitted Britain faced a “choppy recovery” because inflation was proving more resistant than expected and businesses were still struggling to get hold of credit.

STICKY INFLATION

British inflation has been well above that in the euro zone and the United States for the past two years, due mainly to a weaker currency causing higher import prices, and more recently a Jan 1 increase in sales tax that will be repeated in 2011.

Lower transport and clothing costs than a year ago helped inflation fall this month, but the decline was limited by rising food prices and sticky inflation in the service sector.

“We’re likely to have a prolonged period of high inflation but I don’t think that will influence the Monetary Policy Committee too much. They seem more focussed now on the 2-3 year horizon rather than being wedded to the 2-year forecast,” said UBS economist Amit Kara.

Gilt futures were little changed either on the data or King’s letter, as it reinforced the market view following the inflation report that the Bank would not start to raise interest rates from a record low 0.5 percent until well into 2011.

“There were no real surprises here,” said Investec economist Philip Shaw. “The detail highlighted both the upside and downside risks. Most MPC members have offered the view that they can ‘look through’ high rates of inflation in the short to medium term, providing that measures of inflation expectations remain subdued,” he added.

Despite above-target inflation and unexpectedly strong second-quarter GDP, most Bank policymakers are concerned that economic recovery could falter due to weak overseas demand, limited bank lending and looming government spending cuts.

The ONS said the biggest downward effect on CPI inflation in July came from transport costs, particularly the prices of second-hand cars and fuel, reducing the annual rate by 0.14 percentage points.

There was also the sharpest clothing discounting for this time of year since 2002, reducing the annual CPI rate by 0.11 percentage points.

However, rising prices for food and non-alcoholic beverages added 0.16 percentage points to CPI, with the largest upward effect from vegetables. Less discounting in the furniture and household goods sector than last year also pushed up the annual CPI rate, adding 0.06 percentage points.

Retail price inflation, a longer-running measure used in many commercial contracts, slowed to 4.8 percent from 5.0 percent, a slightly bigger fall than forecast.

Additional reporting by Matt Falloon, Christina Fincher and Adrian Croft; Editing by Hugh Lawson

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