Inflation will rise sharply, says Mervyn King

Inflation will rise sharply in the first half of this year before falling back next year, the Governor of the Bank of England, Mervyn King, has said.

But he said there were "large risks" that inflation could overshoot or undershoot the Bank's 2% target.

He reiterated his belief that external factors, such as rising food and energy prices, are the main cause of rising prices in the UK.

Mr King said growth would be weaker than the Bank forecast in November.

He also sought to play down reports the Bank had signalled that interest rates would need to rise this year in order to try to bring down inflation.

"Some people are running ahead of themselves and saying that we are pre-announcing or laying the ground for a rate rise," Mr King said.

"That decision has not been taken and won't be taken until we get to the next meeting or the following meeting, or it may be many quarters."

'Large risks'

In the Bank's inflation report, the governor said that once cost pressures from high commodity prices subside, "CPI inflation will then fall back. But the extent to which it will do so is uncertain, and there are large risks in both directions."

The governor said if businesses and households expected that high inflation was here to stay, prices and wages might rise even more quickly.

On the other hand, as the effects of the rise in VAT to 20% implemented in January and imported cost pressures began to diminish, there was a risk that weak growth "will push inflation well below target," he said.

On Thursday, official figures showed that inflation, as measured by the Consumer Price Index (CPI), rose to 4% in January from 3% in December. Measured by the Retail Price Index (RPI), which includes mortgage interest payments, it rose to 5.1% from 4.8%.

Mr King was forced to write a letter to the Chancellor, George Osborne, to explain why CPI inflation was twice the Bank's target rate.

Split on rates

Mr King said there were "real differences of view" in the Bank's Monetary Policy Committee (MPC), which sets interest rates, about "the likely path of inflation in the medium term".

Two members, Andrew Sentance and Martin Weale, have already voted to raise interest rates, currently at a record low of 0.5%, to combat rising prices.

The split reflects the wider debate among economists, with some arguing that rates should be increased to prevent inflation rising further, and others maintaining that a rate rise would jeopardise the fragile economic recovery.

In light of Tuesday's figures showing inflation rising faster, and Mr King's letter to the chancellor, more observers believed the Bank would raise rates sometime over the summer.

Mr King wrote: "The MPC's-central judgement, under the assumption that Bank Rate increases in line with market expectations, remains that inflation will fall back so that it is about as likely to be above the target as below it two to three years ahead."

Before the inflation report, the market was expecting a rate rise in May, with perhaps two further rises later in the year.

Previously, Mr King had said that inflation would come down without interest rate rises.

'Over-interpreted'

However, some observers read Mr King's comments on Wednesday as meaning a rate rise was not imminent.

"It looks as though markets may have over-interpreted [Mr] King's line on inflation in yesterday's letter to the chancellor," said Philip Shaw at Investec.

Raghav Subbarao at Barclays Capital said: "We think the market interpreted the letter yesterday as being more hawkish... Clearly the inflation report is dovish and downplays the possibility of a rate rise."

Mr King said the recovery was "unlikely to be smooth", while the Bank's economic growth projection for most of this year was now "weaker" than it forecast towards the end of last year.

The BBC's Stephanie Flanders suggested that the Bank's expectation of slower growth and higher inflation would have an impact on its interest rate policy.

"The implication is that Bank Rate will need to go up sooner than the MPC previously thought, and without such a strong economic recovery," she said.