A record monthly jump in prices drove British inflation to an 8-month high in December, piling pressure on the Bank of England to raise interest rates and show it is not letting inflation get out of control.
Concern the BoE has lost its grip on inflation has risen to such a level that markets are increasingly pricing in an interest rate rise by the summer to prevent a full-blown credibility crisis.
"This raise is becoming much more difficult for the Bank of England. Certainly there's going to be a market expectation that they move much sooner rather than later," said Ross Walker at RBS Financial Markets. "So I think you'll start to see a May hike getting priced in quite soon."
The Office for National Statistics said the annual rate of consumer price inflation rose to 3.7 percent last month from 3.3 in November after prices rose a record 1.0 percent between November and December.
This was much higher than analysts' forecasts for a steady reading.
The pound shot up more than half a cent against the dollar to an 8-week high <GBP=>, gilt futures dropped to a contract low <FLGH1> and interest rate futures <0#FSS:> fell sharply as investors bet the BoE will start tightening policy sooner.
Inflation has been at least a percentage point above the BoE's 2 percent target throughout 2010, and rising inflation expectations among the general public and bond investors have caused markets to price in a rate hike by mid-year.
Inflation is likely to climb yet higher in January after an increase in value-added tax to 20 percent from 17.5 percent.
"The numbers are obviously a lot worse than expected. I think it does raise the risk that the Bank of England will have to move interest rates in the first half of this year," said George Buckley, economist at Deutsche Bank.
With harsh public spending cuts about to bite, the government would probably be content for interest rates to remain at rock bottom levels.
But Prime Minister David Cameron did say earlier this month he was concerned about price pressures "well outside what the Bank of England is meant to deliver."
If the BoE does increase rates, it will not have an immediate impact on the CPI. But it may limit firms' abilities to hike prices due to gains in raw material and other costs, and should help to control inflation expectations that hit a two-and-a-half year high in December. [ID:nLAH006830]
CREDIBILITY CRUNCH
The BoE forecast in November that inflation would average around 3.2 percent in the fourth quarter of 2010. More recently policymakers have said it could hit 4 percent early in 2011, due to January's VAT rise.
Oil prices <LCOc1> are fast approaching $100 a barrel, more than $10 a barrel higher than the BoE assumed in its November Inflation Report.
But policymakers argue the factors driving prices at the moment are temporary, and that raising interest rates in response risks de-railing a fragile economic recovery.
Quarterly economic growth is expected by many economists to slow to around 0.2 percent in the first half of the year, as a four-year programme of public spending cuts starts to bite.
"It's stagflation-lite," said BNP Paribas economist Alan Clarke. "Higher inflation is going to make life worse for consumers."
Monetary Policy Committee member Paul Fisher said in an interview published on Tuesday that although inflation was "very uncomfortable", the BoE had made the right decisions on policy.
"We have to look through those short-term things, despite whatever unpopularity comes our way, to try and set the best policy rates for the medium term," he told the Yorkshire Post newspaper. [ID:nLDE70H0O9]
Before Christmas, Fisher said it was possible the economy could shrink for one quarter.
The ONS said the biggest drivers of inflation last month were air transport, fuel, utility and food bills. Fuel costs rose at their fastest annual rate since July, and food prices showed their biggest annual rise since May 2009.
Britain's finance ministry reiterated the BoE's view the rise in inflation was due to one-off factors, and said monetary policy decisions were up to the central bank.
The retail price inflation gauge, which includes more housing costs and is the benchmark for many wage deals picked up to 4.8 percent from 4.7 percent, in line with expectations, and the highest since July 2010.
