UK Inflation Surges But BoE Cools Rate Rise Outlook

Britain's inflation rate rose in May to its highest since the Labour government came to power in 1997 but the Bank of England played down the risk of early interest rate rises by saying the path for rates was still "uncertain."

The Office for National Statistics said on Tuesday consumer prices rose 0.6 percent last month, taking the annual rate up to 3.3 percent from 3.0 percent in April -- higher than forecasts for an inflation rate of 3.2 percent.

The rise above 3.0 percent meant BoE Governor Mervyn King had to write an open letter to the government explaining what the central bank would do to bring inflation back to its 2 percent target.

The Bank of England revised up its short-term inflation forecast but said there were both upside and downside risks to the outlook and that the central bank faced a difficult balancing act between slower growth and rising prices.

"It's less hawkish than it could have been. Indeed, King even made some quite dovish comments and blamed most of the rise in inflation on global issues," said Paul Dales, economist at Capital Economics.

"Our sense is that this means interest rates are likely to stay on hold for now. The Bank does not seem to be in a rush to move in either direction," he said.

Short sterling futures climbed higher after the letter was published and sterling extended losses against the dollar as analysts interpreted it as reducing the chances of interest rates rises this year.

"(King) is accepting that the inflation profile in the near term is higher than that projected in the inflation report. But he's also stressing the longer term downside risk to inflation which is probably why short sterling is rallying so much," said Brian Hilliard, economist at Societe Generale.

"Overall this is a relief for interest rate markets."

Under the BoE's remit, King has to write an open letter to the government if inflation deviates more than one percentage point away from the official two percent target.

This has only happened once before -- last April -- since the BoE was given control of interest rates 11 years ago.

The BoE had expected the rise in consumer prices.

It forecast last month that inflation could rise near to 4 percent and in the letter said it could now rise above that rate.

Its policy direction is likely to be guided by the outlook for inflation over a two-year horizon, especially as a slowing economy is expected to tame price pressures.

The May inflation data showed food and non-alcoholic beverages added 0.14 percentage points to May's annual rate -- the largest contribution.

Housing and household services added 0.09 percentage points as utility bills rose.

"Everything looks strong: services, goods, food, utilities. (This) highlights the severity of inflation pressures hitting the UK," said Michael Saunders, economist at Citi.

The BoE's dilemma is that growth is slowing at the same time as inflation is rising rapidly, a situation that is being mirrored globally.

>> Click here for interview on the UK's May CPI Data