Sterling could yet slay the dragon of inflation

What a week! The economic news flow has been thick and fast. Over the last few days, even the tabloids have published front-page articles on arcane financial concepts.

That's because UK prices are now rising at their fastest rate for 16 years. Inflation reached 3.1 per cent in March - as measured by the Consumer Price Index - up from 2.8 per cent the month before.

The more trusted Retail Price Index, which includes housing and fuel costs, is also a cause for concern. RPI inflation rose at 4.8 per cent last month - its highest annual rate since July 1991.

CPI inflation is now more than a full percentage point above the 2 per cent level targeted by the Bank of England's Monetary Policy Committee. That forced Governor Mervyn King to pen an "explanatory letter" to the Chancellor last week - for the first time in the MPC's 10-year history.

The "shock" inflation overshoot, and King's letter, mean that rates are almost certain to rise to 5.50 per cent in May - the fourth increase in nine months. With UK households shelling out more than 20 per cent of their incomes on servicing debt - including mortgages, credit cards and personal loans - that will cause real pain.

But I don't accept the warning cries of some economists that borrowing costs will balloon further, reaching 5.75 or even 6 per cent.


My reasons are contained in King's letter, in the minutes of the MPC's recent meeting (also released last week) and in the observation that the pound has now broken through the $2 barrier - taking sterling to its highest level against the greenback since 1981.

Yes - the current situation is serious. With households overstretched, and the financial markets looking shaky, a multiple-rise in UK borrowing costs could cause big problems.

It is worth noting, also, that the Bank's monthly "summary of business conditions" points to future inflationary pressures. Having talked to some 230 companies across the country, the Bank's agents report that bosses are intending to engage in "margin rebuild".

As our graphic shows, more than 60 per cent of firms seek to increase profits over the coming 12 months by not passing on cost cuts - double the share which did so last year. Little wonder that the MPC is vowing to "consider very carefully" the extent to which such behaviour will feed into higher inflation.

Having said all that, I still think 5.5 per cent will mark the peak of this interest rate cycle. One reason is that this latest price spike could prove to be temporary. In his letter to Brown, King rightly observed that "inflation has recently been rather volatile from month to month".

As the fine print makes clear, the March CPI figure was skewed by a sharp rise in furniture price inflation - up from 1.5 to 5 per cent - as retailers prepared to fool us with this month's "Easter Special Offers". As this one-off effect is reversed, CPI will fall.

King's letter also stresses that "energy effects" are set to fade rapidly over the coming months. Following last year's fuel price rises, previously announced cuts in gas and electricity bills will bring the CPI down too.

And it's worth noting that despite the worrying March figure, the CPI still averaged 2.9 per cent over the first three months of this year - exactly the rate the Bank predicted in its Inflation Report back in February. That's why King last week told the Chancellor that "this latest news seems unlikely to alter the broader picture".

As for the MPC minutes, they show that no fewer than seven of the nine MPC members voted to "hold" rates earlier this month, arguing that "any change would be better explained in the context of the May Inflation Report projections".


That suggests next month's rate rise - which will coincide with the publication of the Bank's quarterly analysis of price trends - was already a done deal, even before the committee learnt that the CPI hit 3.1 per cent in March.

The big question arising from last week's inflation news would therefore seem to be whether rates will rise beyond 5.5 per cent. And I don't think they will - not least because of the pound.

The $2 pound means UK consumers will benefit from cheaper prices for some imported goods. Given that oil, metals and many other raw materials are typically quoted in dollars, the strength of sterling will also significantly cut many firms' input costs.


So, a stronger pound, while undermining UK exports, could prove to be a blessing in disguise. By holding down the price of finished imports, and raw materials, sterling may end up being the crucial factor which stops rates rising above 5.5 per cent.

Gordon Brown certainly hopes so. With Labour facing crucial local elections, and the Chancellor's record under serious scrutiny, the last thing Brown needs is the spate of bankruptcies and house repossessions which would likely follow if interest rates hit 6 per cent.


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Skills shortage won't go away

Another source of inflationary pressure is - as this column has often said - our skills shortage.

The dearth of suitably qualified British workers often hinders output. So, in the face of rising demand, prices are pushed up.

Last week I was privileged to act as chairman at a debate on "Risks to Business" hosted by the Royal Society of Arts in London. The skills issue loomed large.

The Government's recent Leitch Review concluded that unless Britain "doubles skill levels by 2020", we had no hope of remaining globally competitive.

But as Mary Chapman, the chief executive of the Chartered Management Institute, told the RSA: "Our demography means that no less than 70 per cent of those who'll be working in 2020 are already of working age. So the current skills shortage could prove to be an ever-present challenge."

Motivating firms to train both existing workers and new recruits is tough. Bosses are often unimpressed these days by home-grown school leavers and graduates.

So there's a real danger that, as labour becomes more globalised, millions of British workers will simply get left behind. As Richard Lapthorne, the shrewd chairman of Cable & Wireless, told the RSA: "I can employ Indian engineers at a sixth of the price of my UK engineers. And many of them are perfect - kids who have just left university and are able to adopt a new culture."


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Euro flips Ireland from boom to bust

Since the Republic of Ireland adopted the euro in 1999, its central bank has kept a low profile.

That's because, like all Eurozone members, Ireland's interest rates are now set by the European Central Bank in Frankfurt.

But last week the men in Dublin raised eyebrows when they issued a veiled warning that their high-growth economy was being undermined by euro membership.