Page last updated at 11:05 GMT, Tuesday, 12 August 2008 12:05 UK

Soaring inflation could fall back fast

By Hugh Pym
BBC economics editor

Not so long ago if you had said inflation would rise to double the Bank of England's 2% target rate you would have got some funny looks.

A power socket
Two of the big six energy companies have raised prices recently

But it's not quite so funny now - at least for the policymakers at the Bank of England.

What's more, it's double the target rate, with annual inflation, measured by the Consumer Prices Index, hitting 4.4% in July.

The International Monetary Fund said last week it believed the UK inflation rate could even touch 5% in the months ahead.

One analyst this morning said that now looked like a "racing certainty".

So the Governor, Mervyn King, will have to write again soon to the Chancellor, explaining what has gone wrong.

Sounds bad - but how bad?

There is a fair amount of sympathy for the Governor.

There is not much he can do about surging oil prices, caused by rampant demand in the developing economies, never mind spiralling food costs.

And he is not alone - inflation in the eurozone is already at 4%, and in the United States it is at 5%. Nobody is immune from these global price hikes.

That will not be much consolation for households trying to find the cash to pay for these bills.

Food prices were 13.7% higher in July that in the same month a year earlier.

Motorists were paying 25.7% more for fuel and lubricants.

There is a big squeeze on incomes.

Consumers are having to take the pain for bringing inflation under control.

Falling soon

Most economists expect inflation to fall as rapidly as it has risen - on the assumption that increases in utility, fuel and food prices will not be repeated next year.

Fuel pump filling up a car
Fuel prices have come down from their peaks

The Bank's Monetary Policy Committee will still be fretting that surging inflation does not trigger higher wage settlements.

Their fear is that employers will give way to bigger pay demands and pay for them by raising prices, so pushing inflation up again.

That is why we have been hearing tough talk from both the Governor on the need for pay restraint - if it gets out of control, he is implying, expect higher interest rates.

But, based on the evidence so far, there is not much to worry about.

Since the middle of last year, inflation has gone from less than 2% to more than 4%.

But according to Incomes Data Services, which monitors pay settlements, average wage deals across the economy have stayed consistently at about 3.5%.

Weakness ahead

That may change and the Bank of England will need several months more data to be convinced the wage/price genie is not out of the bottle.

On the inflation front, there are a few tentative signs the tide may be turning.

Oil prices have tumbled on the world markets in recent weeks, with pump prices coming down as well.

Figures yesterday showed that the prices paid by manufacturers for raw materials fell at their fastest monthly pace for a year and a half - though they were still nearly a third higher than a year ago.

And it could just be that the Bank has a bigger inflation problem further down the track - with annual cost of living increases falling too fast.

That might well happen if the economic slowdown turns into a mild recession.

A deeper and prolonged downturn would pull inflation right down, and the Bank may find itself cutting interest rates rapidly to keep the economy afloat.

Households could be in for more pain next year if rising unemployment becomes a bigger worry than increases in the cost of living.

Right now, if you said inflation would plunge below the 2% target, you would get some funny looks, but monetary policy is a funny old business.

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