Headline inflation at two-year high

Higher mortgage rates, more expensive petrol and alcohol since the Budget and a seasonal rise in the cost of food pushed the headline rate of inflation last month to its highest level for almost two years. Including all those factors, the RPI jumped to 3.3 per cent from 2.9 per cent in June.

The stock market shrugged off the rise, focusing on an unchanged underlying inflation rate, excluding home loans and indirect taxes, of 2.2 per cent. Despite the highest headline rate since September 1995, when the RPI was 3.9 per cent, the FTSE 100 index of leading shares closed 43.9 points higher at 5075.8.

Economists agreed that the cost of living data justified the Bank of England's recent hint that interest rates were now high enough to contain inflation at its 2.5 per cent target. Despite strong retail sales volumes, the latest figures showed discounting on the high street remained as deep as last year, with consumers demanding lower prices even when they were spending the proceeds of the recent building society windfalls.

On the high street, household goods inflation held steady at 0.9 per cent, while clothing and footwear prices nudged up by only 1.1 per cent. Underlying inflation would actually have fallen had it not been for a jump in seasonal food price inflation which almost certainly reflected recent damage to crops.

The official inflation figures came just before today's quarterly Inflation Report from the Bank of England, which will be its first assessment of the inflation outlook since it assumed operational independence for setting monetary policy. Previously the Bank advised the Chancellor on interest rates, but he could (and often did) ignore its recommendations.

Now the forecasters and policy-makers are the same people, the report will be raked over with a fine tooth-comb by analysts looking for clues about the likely direction of interest rates.

The Government's Paymaster General, Geoffrey Robinson, said he expected to see RPI-X, the underlying inflation measure that excludes only mortgage payments, back down within a couple of months as the full effects of the July Budget showed through in the official statistics.

He said: "Next month we will get the benefit of the cut in VAT on fuel. We are confident we will see inflation come down over the next few months, very much in line with the target we have set."

Last week the Bank increased interest rates by a quarter point to 7 per cent, the fourth rate rise in as many months. It has been concerned that a flood of windfall gains from the conversion of mutually owned building societies to banks would tip already strong consumer spending over into an inflationary boom.

Jonathan Loynes, UK economist at HSBC, welcomed the data: "The figures are much better than they look at first sight, with all of the upward pressure coming from mortgages, taxes and the erratic seasonal food component. Underlying inflation pressures remain very subdued with clear signs that lower costs are feeding through to the high street."

Not everyone was as sanguine. Rosemary Radcliffe, head of economics at Coopers & Lybrand, said she believed the Bank's interest rate "amnesty" might not last long. "Our view is that the Bank will probably need to raise rates further later this year or early next year to control the inflationary pressures now building up."

She predicted a rise in RPI-X from July's 3.0 per cent to 3.4 per cent by the fourth quarter of next year.