King readies pen as BoE predicts prices to soar

At the press conference following the publication of the Bank's gloomy Inflation Report, Central Bank News heard the Bank's governor say that the outlook for inflation had "deteriorated markedly" since February and that rising energy and food prices would "almost certainly" push inflation more than one percentage point above the Bank's 2% target.

Since 1997, when the Bank was granted monetary independence, the governor has had to pen an open letter to the chancellor of the exchequer if CPI inflation exceeds 3%. If the measure remains above 3% for more than three months, King must write again to the chancellor, detailing why inflation remains so high.

Inflation, King said on Wednesday, was likely to remain above 3% for several quarters, meaning that he would be required to write a number of letters to the chancellor.

The Bank's Inflation Report shows it now expects the CPI measure to reach at least 3.5% in the coming months. Its baseline scenario indicates the Bank believes inflation is likely to be above target until at least the end of the first quarter of 2010 and perhaps the second.

"Bumpy road"

The Monetary Policy Committee (MPC) was facing its most difficult challenge yet, King said. "The credit cycle has turned. Commodity prices are rising. We are travelling on a bumpy road as the economy rebalances."

However, he warned that the Bank would not use policy to prevent this adjustment. It was also "not the moment to change the inflation target." "The MPC is facing a difficult situation but we will get through it," King said.

He also stressed that it no longer made sense to bring inflation down to target in a 12-18 month horizon and that the Bank was now aiming for 2% inflation within a two-year period.

Expectations

Both King and Charlie Bean, the Bank's chief economist, stressed that containing inflation expectations - which the latest measures show are now at record highs - was vital.

Inflation expectations were, Bean said, "absolutely essential" to the conduct of monetary policy. "Measures of inflation expectations are not particularly good but we pay a lot of attention to them," Bean said, adding: "What is most important is that inflation expectations remain well anchored in the medium term."

Worryingly, given the recent spike in global oil prices, Bank data shows UK consumers' inflation expectations place the greatest weight on energy costs.

Market reaction

City economists, many of whom announced on Tuesday that they would be revising their inflation forecasts on the back of the shocking CPI figure for April, shifted their rate expectations for the coming year following the publication of the Inflation Report.

"Our view had been that the MPC would cut rates to 4.25% by year end and to 4% in the first half of 2009," Michael Saunders, an economist at Citi, a bank, said. "We still expect the MPC will cut by 100 basis points or so - but as inflation expectations surge and the near-term inflation spike climbs ever higher - we now expect easing to be delayed. Our new base case is for a 25 basis point cut in the rest of this year, with rates falling by 75 basis points in 2009."

Click here to read the Inflation Report

Click here to watch the webcast of the press conference