Where next for inflation?

Analysis By Hugh Pym Economics editor, BBC News

The spectre of rising inflation is haunting the world's leading economies - and the UK is no exception.

Higher food and energy bills boosted inflation in May

Soaring oil and food prices have pushed up the cost of living just when economic growth is slowing.

Fears of stagflation, stagnant growth combined with accelerating inflation, have resurfaced, conjuring up images of the 1970s.

On Monday, the eurozone inflation rate was reported at 3.7% in May, up from 3.3% and the highest since modern records began in the mid-1990s.

US inflation on a comparable measure was 4.2%.

Now the UK has reported its own record-breaking 3.3%, up from 3% the previous month (as measured by the Consumer Prices Index).

It's a sobering thought that the annual rate was as low as 2.2% in January.

The inflation, and hence interest rate, outlook has changed dramatically in the last few months.

Uncertainty looms

Not long ago, the main worry was the credit crunch and a possibly dramatic economic slowdown.

Many economists predicted a rapid fall in Bank base rates from 5% to 4% or even lower.

But recent commodity price hikes, particularly oil, have transformed thinking both in the City and at the Bank of England.

In his letter to the chancellor, the governor notes that "unanticipated increases in the prices of food, fuel, gas and electricity� account for 1.1 percentage points of the 1.2 percentage points in the increase in the CPI inflation rate since December".

Mervyn King points out that there have been global price changes.

He says there are good reasons for the period of above-target inflation to be temporary.

Although inflation, he says, could rise to above 4% later this year, in the absence of further unexpected commodity price rises, it should fall back towards the 2% target.

But the governor stresses the uncertainties of the outlook and the worry that rising inflation will fuel higher wage demands.

There is a hint that, at best, interest rates will remain where they are for some time to come till the Bank is certain the inflationary threat has passed.

There is also a clear indication that rates will rise if necessary.

And that will be consolation for those struggling in the housing market who have been pleading for lower rates.

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