Bill Jamieson: Surge in inflation to 3% leaves Labour with triple strength headache

WITH Bank of England governor Mervyn King warning that inflation is likely to rise to more than 3 per cent "for a while or even higher for even longer", Chancellor Alistair Darling has been put on the spot.

It spells trouble on three fronts. First, it threatens recovery by bringing forward the likelihood of an interest rate rise. Second, it threatens to drive up the cost of government borrowing and debt. Debt interest charges are set to hit 44 billion in 2010-11and the government will have to sell some 225bn of gilts to an apprehensive market. And third it could deal a crippling blow to government credibility if no early action is taken.

Pressure will intensify for an early budget to announce clear plans for bringing down the deficit – and an election soon after. Leaving the election date until May with inflation going up leaves Labour vulnerable to a rising expectation of increasing interest rates.

Mr King warned in a speech at Exeter University that "the patience of UK households is likely to be sorely tried over the next couple of years". He said: "There is little scope for growth in real take-home pay, which may remain weak even as output recovers. It is clear inflation is likely to pick up markedly in the first half of this year".

Michael Saunders, UK economist for Citigroup, sees consumer price inflation (CPI) staying above 3 per cent to mid-2010 at least, with headline RPI inflation – the rate most commonly used for pay bargaining – rising to 5 per cent.

"The MPC", he writes, "is likely to hike rates relatively early this year (we expect the first hike in Q2 or Q3) and could be forced to act especially sharply if inflation expectations surge or if the UK continues to lack a credible programme to return to fiscal sustainability after the election (eg if there is a hung parliament)".

Monetary Policy Committee member Andrew Sentance hinted last week rates would be hiked if inflation surged.

Sterling and bond yields jumped yesterday as investors worried that the biggest rise in yearly core CPI since records began in 1997 would encourage central banks to bring forward monetary tightening.

"Inflation nerves will be sorely tested in the next months," said Jonathan Loynes, chief European economist at Capital Economics.

Mr King still asserted last night that with monetary growth "well under control" at present "undesirably low", inflation "should return to target in the medium term". But that is little comfort to a Labour government with an immediate need to assert its credibility if it is to close the poll gap on the Conservatives.