Rate rise nears as inflation hits 4% By Julia Kollewe

• VAT rise helps lift inflation to twice Bank of England's target
• Governor Mervyn King hints at interest rate rise in spring

Higher petrol prices helped push up inflation in January. Photograph: Russell Boyce/Reuters

The prospect of an interest rate rise this spring has increased after the cost of living rose to 4% last month, the highest annual inflation rate in more than two years and twice the Bank of England's target.

The Bank has been caught out by rising inflation and is under growing pressure to raise borrowing costs from the current 0.5% sooner rather than later, despite the economy's sluggish recovery. In his obligatory letter to the chancellor, George Osborne, the Bank's governor, Mervyn King, admitted that the rate-setters on the monetary policy committee (MPC) were deeply divided over whether or not to increase rates but hinted that an early rate rise could be in the offing.

Explaining why inflation is so far above the Bank's 2% target, he blamed it on the increase in VAT to 20% in January, the weak pound and the commodity price boom, in particular energy. Petrol and other fuel prices went up by 4.4% between December and January, with Brent crude oil now hovering near $104 a barrel. Inflation is likely to continue to pick up to somewhere between 4% and 5% over the next few months – "appreciably higher" than when he last wrote to the chancellor three months ago, King admitted.

The Bank is under pressure to defend its inflation-fighting credibility, said Ross Walker, UK economist at Royal Bank of Scotland. "I don't think anybody believes the economy has returned to rude health, but [policymakers] recognise that inflation is higher than they forecast and that people are increasingly questioning their anti-inflation credibility.

"It's a very complicated outlook but it's possible they will raise [rates] in March. If it's a precautionary move they could follow it up with one or two quarter-point hikes later in the year."

The Bank is expected to prepare the ground for higher rates when it publishes its quarterly inflation and growth forecasts .

Michael Saunders, western Europe chief economist at Citi, said the governor's letter seemed to endorse the market's view that interest rates would start rising soon. "Last week's decision to leave rates on hold looks like a tactical pause ... We continue to expect a hike in the next three months."

King hinted at the growing disagreement on the MPC over whether and when interest rates should go up, saying "there are real differences of view within the committee". Martin Weale, who only became a member of the MPC last summer, joined the arch-hawk Andrew Sentance, who has voted for higher rates since June, in backing a quarter-point rise in January.

King wrote in the letter: "The MPC's central judgment, under the assumption that Bank Rate increases in line with market expectations, remains that, as the temporary effects of the factors listed above wane, inflation will fall back so that it is about as likely to be above the target as below it two to three years ahead.

"The MPC judges that attempting to bring inflation back to the target quickly risks generating undesirable volatility in output and would increase the chances of undershooting the target in the medium term," he wrote.

Money markets have priced in a quarter-point rate increase in May and two more by the end of the year, while economists have been more cautious.

However, King's comments prompted Philip Rush, UK economist at Nomura, to change his forecast to pencil in a rate rise at the Bank's May meeting. "Following the inflation release, Mervyn King effectively endorsed market rate expectations," Rush said. "We now expect the next move from the Bank of England to be a quarter-point rate hike in May with balanced risks around the timing. This hike is additional to those we had previously pencilled in every three months from August."

Simon Hayes, chief UK economist at Barclays Capital, is also reviewing his rate prediction: "The inflation report should provide further information about the rate outlook, but today's letter implies that the MPC is a little more impatient to raise rates than our current forecast of the first rate hike in November suggests."

The higher cost of petrol along with rising alcohol, furniture and restaurant prices following the VAT increase fuelled the rise in consumer price inflation to 4% from 3.7% in December, official figures showed. Inflation is now at its highest since November 2008.

Alan Clarke, UK economist at BNP Paribas, summed up the feeling in the City by saying the figures were "not as bad as feared, but still bad". Prices rose 0.1% between December and January, the first increase on record between those two months. The two main factors were the surge in oil prices and the VAT rise, the Office for National Statistics said.

Some components reflected the VAT increase more than others. Those that increased a lot due to VAT were alcohol and tobacco, furniture, restaurants, cafes and hotels. By contrast, clothing was hardly affected because of the January sales and as many retailers postponed passing on the VAT rise.

Annual inflation measured by the retail prices index, which unlike the consumer prices index includes housing costs, increased to 5.1% in January, from 4.8% in December. Pensions and many wage deals are based on this RPI measure.

King recently warned that families faced the biggest squeeze on their spending power since the 1920s, with inflation-adjusted wages having fallen over the past six years.

The chancellor responded to King's letter by acknowledging that commodity price rises had been "a key driver of recent UK inflation" and said the government was taking steps, including within the G20, to make commodity markets work better.

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