King prepares to eat humble pie

Rising prices of energy and food mean that inflation is set to stay higher than the Bank of England's target for a prolonged period, forcing the Governor to write another letter of explanation

There are three central facts about British inflation – the unavoidable background to today's news on inflation and tomorrow's definitive Inflation Report from the Bank of England. First: The Bank's job is to keep inflation at 2 per cent "at all times". Second: The Bank has recently failed to do that. Third: there is little prospect of inflation returning to target soon.

Almost without the nation realising it, stagflation – stagnating output coupled with high inflation – may soon be about to revisit Britain for the first time in three decades. That old phenomenon has been recreated by the unprecedented confluence of two new ones: the credit crunch, which has choked off the supply of lending to the economy, and the commodities boom, which has pushed prices up and sucked even more purchasing power out.

The Bank of England has almost admitted that, so far as 2008 is concerned, it is powerless to do anything about this. Inflation is "baked in the cake" as officials say. Interest rate changes take anything from a year to two years to feed through. In the recent words of Mervyn King, the Governor of the Bank: "It doesn't make sense to raise interest rates at this stage to induce a recession to keep inflation below 3 per cent."

The rate rises that were pursued over 2006 and 2007 to get inflation back under control had to be abandoned when the credit crunch started to bite. The fear then, as now, was of a slump. Inflation has proved no less dangerous an enemy. The MPC knew today's CPI numbers when it held rates last week, and that information was probably decisive.

So the economy will slow; and inflation will rise. This time next year, or even in 2010, the Government could well be in the middle of an election campaign with the economy still in the doldrums and inflation eating into peoples' living standards. The political, as well as the economic, stakes are high.

Yesterday's figures on so-called "factory gate" inflation, the producer prices index, could scarcely have been worse. The boom in commodity and food prices is behind much of the bad news; crude oil is up about 25 per cent so far this year; food prices continues to hit record highs; gas and electricity costs continue to escalate. Chinese inflation was recorded yesterday at more than 8 per cent – a sign that the era of cheap goods from that source is drawing to a close. The 12 per cent deprecation in sterling since last autumn has done the rest.

This "triple whammy" has seen input costs soar. The Office for National Statistics reported that input prices for manufacturers jumped 2.4 per cent during the month of April alone. This lifted the annual rate of input price inflation to 23.1 per cent, reminiscent of the 1970s. It is a record high for this series, which began in 1986.

In terms of output price inflation, the selling prices for manufactured goods, these surged by 1.4 per cent on the month and 6.5 per cent on the year. This is also the highest since the 1980s.

Producer price inflation is a leading indicator of retail inflation, so the signals are worrying. They indicate that the period of excessive inflation could be longer than had been previously feared. Indeed such an outcome was conceded by Mr King, when he told the Treasury Select Committee on 29 April that: "It's likely that inflation will reach 3 percent, or possibly higher, because of the impact of higher food and energy prices. The period over which it is likely to be close to 3 percent is longer than it was last year."

Last year, inflation stayed over 3 per cent just for April. This year it is likely to be less of a spike and more of a plateau. Some economists are predicting that the 3.1 per cent threshold, at which the Governor must write a letter of explanation to the Chancellor, will be breached for much of the rest of this year.

If it stays beyond the 3.1 per cent mark for more than three months a further letter from the Governor will be required. In its February Inflation Report, the Bank said inflation, on its central projection, would be back close to target by Christmas this year. That may be significantly postponed. The Bank will note how inflationary expectations have been climbing, and the lack of faith the public display in official measures of inflation. Too many things they must buy every day or every week – petrol, food, rail fares, electricity and gas bills – are going up rapidly. But the prices that are stable or falling tend to be for items bought infrequently and in a discretionary way, and which consumers are anyway less likely to be able to afford because of the soaring price of basics: second-hand cars, electrical goods, and now houses (though the latter have been kept out of the official figures).

The remit of the Bank's Monetary Policy Committee is clear. In March, Alistair Darling formally told them that "the inflation target is 2 per cent at all times". Yet there is wriggle room.

Kate Lomax, the deputy governor for Monetary Policy, has pointed out that "we have discretion to decide how fast to return inflation to target, if it is thrown off course by a sharp shock, such as the current surge in world energy prices. So we are not required to raise interest rates sharply to counteract the rise in inflation which we expect over the next few months."

Ms Lomax described the Bank's dilemma succinctly: "Policy needs to balance two significant risks: first, that financial stress will precipitate an unduly sharp slowdown in demand, which will bear down so heavily on inflation that it undershoots the target; and second, that temporarily high inflation will lead to inflation expectations persisting at too high a level."

Still, the fact remains the Bank has kept inflation at or below the 2 per cent target rate for only five of the past 24 months. The prospect is that it will remain at above 3 per cent for most of this year, and yet the Bank is seen, perversely by some, to be cutting rates for fear of provoking a slump and undershooting the 2 per cent target.

"Mr King has said in the past that the Inflation Report and any letters he must write to the Chancellor of the Exchequer are a welcome opportunity for him to explain how the MPC expect to bring inflation back to target and over what horizon."

In tomorrow's Inflation Report, Mr King will have a good deal of explaining to do.

Rising price of food

Energy prices reach record levels

The case of Robert Wiseman Dairies Plc encapsulates the effects the new stagflation is having on business.

The company reported a 20 per cent drop in profit and said: "In recent months we have faced an accumulation of cost and revenue pressures that will, disappointingly, impact our profitability."

Price increases to cover higher expenses have "taken longer to conclude than we had envisaged". The squeeze has forced the company to raise prices again – by a further 0.5 pence per litre of milk from 1 May.

It Is not alone. Output prices among UK food manufacturers rose by 9.3 on the year to April – highest gain in recent years, with import prices for food and drink rising 14.8 per cent.

Food prices in the shops are going up by about 6 per cent a year, with analysts expecting a jump to 9 to 10 per cent by the year end. Record world prices for "soft commodities", from tea to rice, lower sterling and higher energy bills for processing and transporting food are behind the boom.

Demand from the rising and more prosperous populations of China and India, steadily insisting on a richer, more protein-heavy diet, underpins the market.

Food inflation tends to be "high visibility" as consumers encounter it almost every day, so it has a disportionate impact on inflationary perceptions and expectations, helping to institutionalise, for example, higher wage demands, though there has been little evidence of this.

Energy prices are where householders, industry and the Bank of England alike are feeling the heat.

Yesterday, UK natural gas for next winter rose to a record high as the country's biggest energy supplier, Centrica, which owns British Gas, said price increases for household consumers "look inevitable". The company raised gas and electricity bills on average by 15 per cent at the start of the year, while price comparison sites such as uSwitch expect average bills to rise about 10 per cent, or £105, by the autumn.

The winter natural gas contract has jumped 46 per cent so far this year on record crude oil prices and concern that heating-season demand may exceed supply. Warmer weather will take the edge off things, but the stabilisation in energy prices seen during the second half of last year is now well and truly over.

The jump in the CPI in February from 2.2 per cent to 2.5 per cent was almost all down to the increase in domestic utility bills. Again, global forces are at work. The unquenchable thirst for energy from rapidly growing emerging economies such as China has pushed oil prices to levels once thought unthinkable.

A barrel of crude has gone up by 25 per cent so far this year and has risen fourfold since 2004. The president of Opec speaks freely about the price heading to $200 (£102) a barrel. The Western economics are less dependent on oil and less susceptible to increases in energy prices as they used to be, as domestic and industrial users have learnt to be more energy efficient since the first price hike in 1973.

However, increases on this scale will not be easily absorbed. Interest rates would need to be set at punitive levels to contain such an external shock. Higher inflation is inevitable.