BoE credibility erodes as inflation 'surprises' again: Ward

The Bank of England's fantasy forecast of a decline in annual CPI inflation to about 1% in early 2011 looks even less credible in the wake of March numbers showing an unexpectedly large rise from 3% to 3.4%.

The increase partly reflected strength in energy and food prices but "core" inflation also firmed - the CPI excluding energy, food, alcohol and tobacco rose an annual 3%, up from 2.9% in February.

The significant overshoot of the 2% target cannot be attributed simply to January's VAT hike. Assuming 50% pass-through of tax changes, CPI inflation would stand at about 2.5% if VAT and duty rates had been held constant over the last year. (This estimate is derived by averaging the annual increases in the headline CPI and the CPI at constant tax rates, which is calculated assuming 100% pass-through).

The headline rate may rise again in April, possibly exceeding January's 3.5% high. Budget-announced duty increases are officially estimated to add 0.18% to the CPI versus 0.08% in April 2009, while the monthly rise in core prices was unusually low in April last year, implying an unfavourable base effect.

The Bank will be forced yet again to raise its near-term forecast in the May Inflation Report - the February Report projected a second-quarter average of 2.8-2.9%.

Continued core inflation stickiness reflects residual exchange rate effects and a revival in pricing power as the recovery has gained momentum. Consistent with business surveys, services inflation firmed from an annual 3% to 3.3% in March.

Core goods inflation has slowed slightly, reflecting recent sterling stability, but will be underpinned by pass-through of surging input costs - already evident in producer output price numbers.

The persistent overshoot coupled with the Bank's relaxed response have contributed to a significant rise in market inflation expectations, as implied by the yield gap between conventional and index-linked gilts.

The Bank's own estimate of 10-year-ahead implied inflation has risen by half a percentage point since the dovish February Inflation Report to its highest level since August 2008. Early policy tightening is likely to be required to stabilise market expectations and reestablish inflation-fighting credibility.

Simon Ward is the chief economist at Henderson Global Investors.