Analysis: Pushing up interest rates would be a big and unnecessary gamble

The members of the Bank of England's Monetary Policy Committee (MPC) would have been shifting uncomfortably in their seats as the latest consumer price inflation (CPI) figures were released.

The announcement that the annual rate of consumer price inflation rose from 3.3 to 3.7 per cent in December - the highest rate since April 2010 - sideswiped some analysts and increased the ferocity of the debate surrounding the nation's monetary policy. The bulk of the increase has come from external pressures, with surging commodity prices driving up the cost of a range of goods from petrol to domestic fuels to food. And it is going to get worse before it gets better.

We have witnessed further commodity price increases this month, while the range of austerity-related measures - including rising VAT, fuel duty and train fares - has yet to hit the index.

Indeed, it would now be a major surprise should CPI inflation fail to hit 4 per cent - twice the Bank's 2 per cent target - at some point in the coming months. In any case, the figure is likely to remain above 3 per cent for the much of 2011.

However, despite the unease with which the MPC will be viewing the figures and the tension it will undoubtedly be experiencing, we maintain it should not bow to pressure to raise interest rates. VAT continues to account for a large part of the overshoot, while the recent rises in commodity prices should soon start to abate. With no sign of any second-round effects on wages, we expect inflation to drop back to target at the beginning of next year as the VAT rise falls out of the calculation.

The MPC has its hands tied when considering the inflation rate over the next couple of months; it simply cannot do anything to remedy them. But we remain confident this will not distract it from the job in hand, which is targeting inflation two years out.

Some major downside risks remain - particularly the reaction of the domestic economy to the austerity programme - and to raise rates this early would have to be viewed as a significant gamble.

Among other factors, a premature rate rise would be likely to boost the pound, weakening the UK's ability to increase its exports, which we have long suggested hold the key to economic recovery.

• Andrew Goodwin is senior economic adviser to the Ernst & Young ITEM Club.