Cost of living soars as prices rise at fastest rate in six years

May 14 2008 by Iain Laing, The Journal

Your questions answered:

Official inflation yesterday reached 3% after a sudden spike in April - its highest level for more than a year - putting pressure on policymakers at the Bank of England and threatening hopes for interest rate cuts.

Why did inflation jump in April?

April’s sudden 0.5% rise - the biggest monthly rise since July 2002 - was caused by higher gas and electricity bills following price rises from the UK’s ``big six" energy firms. The effect is exaggerated because these bills were coming down last year.

Budget tax hikes on alcohol and tobacco - particularly the 55p duty rise on spirits and 14p extra on wine - have added to pressure, while food prices have also risen at a higher rate than a year ago. Both these factors also affected hotel and restaurant prices.

Other elements behind the rise included soaring prices for video games and miscellaneous services such as mortgage arrangement fees - rising this year but falling 12 months ago.

What other inflation pressures are there?

Oil prices are close to record levels above 120 dollars a barrel, which has driven higher petrol prices and gas and electricity bills, as well as adding to the raw materials costs for a host of manufacturers. Investment bank Goldman Sachs has predicted costs could reach as high as 200 US dollars a barrel.

Meanwhile worldwide demand for food due to a combination of changing diets in emerging economies, poor harvests and increased production of biofuels have also fed in to higher prices at the supermarket.

What does this mean for interest rates?

It means that they may not fall as quickly as previously hoped, despite pressure on consumer-facing industries and falling house prices. The Bank’s mandate is to keep the cost of living at 2% and it risks encouraging inflation by cutting rates too rapidly.

The Bank is walking a tightrope, however, because while it eventually expects a slowing economy to bring inflation back to target, if it waits too long to lower rates the risk of a recession in the UK is higher.

Can the Bank cut rates at all if inflation is above target?

Yes it can, because the Monetary Policy Committee (MPC) attempts to look through short-term inflation pressures with a two-year view on the prospects. The MPC could justify a rate cut now if it believed it would help bring CPI back to 2% in two years’ time, although with inflation unexpectedly high this becomes less likely.

How high could inflation go?

Economists were wrong-footed by the sudden rise in April and some are now predicting that CPI could rise as high as 4% or more - double the Bank’s official target.

Inflation could reach Governor’s Mervyn King’s letter-writing target of 3.1% next month and remain at elevated levels until mid-2009, JP Morgan economist Malcolm Barr predicts. He said: ``This morning’s data suggests that the peak will be at or above 4%."

The Governor must write an open letter to the Chancellor when inflation reaches 3.1%, with further public explanations due every three months until CPI falls below that level.

Sustained oil prices and further energy price hikes would add to the headaches for the MPC, other economists suggest.

Investec’s David Page says that a round of 10% price hikes from energy companies would add 0.45% to the CPI, taking inflation to around 3.5%. He said ``The Bank cannot assume that we are at the peak and all the inflation pressure is in the system."

Why are prices rising while the economy is slowing?

The UK economy grew at its slowest pace for three years in the first three months of 2008 but inflation is on the rise, official figures have shown.

This is the generally accepted definition of ``stagflation" - caused by the ``supply shock" to the UK from higher oil and food prices in an increasingly globalised economy. Industry has to put up prices to cope with raw material costs rising, but production is less profitable and there is less wealth generated.

The added unwelcome factor for both businesses and homeowners has been the surge in the cost of debt since the credit crunch. Banks are tightening up on lending which slows the economy as consumers feel the pinch. A lack of mortgage availability puts the brakes on the housing market, leading to lower prices and again impacting consumer confidence.