Inflation Means Rates Won't Fall Soon

Inflation hit an eleven-year high today and is expected to rise above 4% later this year.

The government's favourite measure of inflation -- the CPI (consumer price index) -- hit 3.3% in May. That means average prices are 3.3% higher than a year ago. This is the biggest inflation increase since the index was introduced in 1997. Mervyn King, the Governor of the Bank of England, has had to write an open letter to Alistair Darling explaining why inflation is more than 1% higher than the 2% target. King blames the recent big rises in food and energy prices. In the year to May: World agricultural prices soared by 60% while UK retail food prices increased by 8%. Oil prices rose by more than 80% to average $123 a barrel and UK retail fuel prices increased by 20%.Wholesale gas prices increased by 160% and UK household electricity and gas bills by around 10%. King also thinks that inflation is likely to rise `sharply' in the second half of this year to above 4%. Interest Rates Central banks normally use interest rates to fight inflation, so I think a near-term cut in the base rate is very unlikely. And there's a decent chance that the base rate could rise soon too. However, having read King's letter, I'd say that rate rises are a bit less likely than I thought 24 hours ago. King says: 'there are good reasons to expect the period of above-target inflation we are experiencing now to be temporary.' That's because, according to King, recent inflation has been mainly caused by rising input prices (food and resources), and not by rapid growth in the amount of money going around the economy (known as the money supply.) King says that money supply growth has eased and credit conditions have tightened thanks to the crunch. So if input prices start to slow down now, then inflation might fall in 2009. That's a big `if' of course. And even if input price rises slow, there's also a danger that recent price rises will feed through into higher `inflation expectations' amongst ordinary people and hence higher pay rises. If that happens, inflation will almost certainly stay high for longer. On top of that, inflation hawks argue that King is wrong to pin so much of the blame for current inflation on commodity price rises. They believe that the fault lies with the central banks worldwide who have kept interest rates too low for too long. What can we do? Well, it's important to keep calm. We may be entering a tough time, but the economy will recover sooner or later. It always does. Until the good times return it's especially important to budget carefully and make sure that you've got the best deals for your mortgage, utilities and insurance. And at least you can benefit from the excellent savings rates that are on offer right now! More: House Price Fall Biggest In 15 Years