Some scary data on cost-push inflation

The government is committed to price stability and has set the Bank of England a target for consumer price inflation of 2.0 per cent. But there are some dark inflationary clouds on the horizon which will test the Bank of England to the limit in the coming months.

Last week the Monetary Policy of the Bank of England decided to cut official short term interest rates by 0.25% - it is the second cut in policy rates in the last few months and, although the Federal Reserve has been more aggressive in reducing interest rates in the United States, the financial markets expect the MPC to cut rates at least twice more later on this year.

But the Bank’s freedom to cut interest rates further is limited by a strong increase in inflation pressures and we have seen some evidence of this in the last few days. The central bank is worried inflation could spiral well above the 2 percent target this year

Part of the worry comes from the data on producer price inflation which measures the prices of goods leaving factories These prices rose at their fastest annual pace in more than 16 years in January, accelerating to 5.7 percent from 5.0 percent in December

Input costs are also rising far too quickly for the Bank’s comfort. The prices of raw materials surged 18.9 percent in the year to the end of January - the strongest rate since the series began 22 years ago. Input costs are being driven higher by record crude oil prices and the soaring prices of many foodstuffs including wheat and sugar.

The danger is that this dramatic acceleration in input and output price inflation will feed through the supply chain of the economy into higher prices in the supermarkets. And once retail price inflation edges higher, the Bank of England is concerned that inflation expectations will increase leading to a pick up in wage demands and unit labour costs.

Consumer price inflation has been above the two per cent target for most of the last year (the data for CPI inflation came out today at 2.2 per cent) and it is almost a year since the governor Mervyn King was forceed to write his first letter to the government explaining why the inflation rate had gone beyond target range. The Bank of England seems to be hoping to weather the coming storm, to hold steady if and when inflation rises well above their preferred level, and hope that oil prices and other input costs will head lower later on in 2008. We will get more analysis from them when they release their latest inflation report tomorrow.

Balancing a slowing economy suffering from resurgent inflationary pressure is not an easy task.