The spike in U.K. annual inflation in December highlights the risk that the huge amount of spare capacity in the economy will have a smaller damping effect on prices than Bank of England policy makers expect.
Official data Tuesday showed that annual inflation jumped to 2.9% in December from only 1.9% in November, marking the largest increase since the official data series began in 1997. That was well above the BOE’s 2.0% target and beat analyst expectations that it would be 2.5%.
While the acceleration in inflation was fueled by several special factors, analysts said the figures raised the likelihood that the BOE won’t extend its quantitative easing policy of buying assets with freshly created central bank money when it reaches its £200 billion target in February.
“Today’s inflation number provides a rare glimpse at inflation undistorted by sales tax changes and shows that inflation has been more persistent in the UK than expected given the scale of economic downturn,” said David Page, U.K. economist at Investec Securities.
The inflation figures rattled financial markets, sending sterling to a fresh four-month peak against the euro, and pushing up yields on UK government bonds. It also spurred U.K. Prime Minister Gordon Brown to stress that the jump had been expected and was likely to be temporary.
“I don’t think we should read too much into one month of figures,” Mr. Brown said at a regular press conference. “Generally, Britain has had over the last 12 to 13 years a low inflation environment that has made possible low interest rates.”
While the figure was significantly higher than analysts had expected, they said the upward move was likely to be temporary, with the large amount of spare capacity in the economy set to damp pricing power, meaning that monetary policy should remain loose for some time.
The ONS said that reflected the government’s temporary cut in the sales tax in December 2008, to 15% from 17.5%, no longer bearing down on prices, as well as the fact that oil prices and early sales also cooled prices a year earlier.
The BOE has said inflation could rise sharply to above 3.0% early this year, which would force Governor Mervyn King to write an explanatory letter to the government.
While the central bank says it will disregard what it expects to be a temporary upward move, policy makers will be alert to any signs that public inflation expectations are becoming de-anchored or that the spare capacity in the economy isn’t damping pricing power as much as thought.