UK inflation hits 4% and increases chances of an interest rate rise

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Sterling was yesterday's star performer on the foreign currency exchange market following Bank of England Governor King’s inflation letter following yesterday’s CPI figures boosted the chances that the Inflation Report today will endorse the market’s view of forthcoming interest rate rises.

It was the consumer price index (CPI) for January that required another letter was sent to the UK Chancellor, which came out at 4.0%, a whole 2.0% above the Bank's inflation target. The contents of the letter however revealed that inflation has the potential to reach 5.0%.

Yesterday's data from the Eurozone showed that, in terms of economic activity, the Eurozone are seemingly somewhere ahead of the UK. The Eurozone's performance, that was largely due to the robust performance of Germany, came in at 0.3% which was slightly below the 0.4% forecast, but still a decent performance in a weather disrupted Q4.

Today's Bank of England Inflation Report will be the major focus for markets, but the latest UK unemployment figures for December and January that precede the inflation report will also be of interest.

Dealing with the jobs numbers first, the numbers of unemployed in the UK are expected to have risen further in the December, whilst the number of new claims is forecast to drop modestly in January. The number to watch though is the more comprehensive International Labour Organisation (ILO) release, since this gives a more accurate representation of labour market conditions. It also punches a fairly large hole in the argument that current high levels of inflation will lead to increasing inflation expectations in terms of wage negotiations.

As for the Inflation Report, Mervyn King's letter to the Chancellor yesterday suggests the Monetary Policy Committee are gearing up for interest rate rises but we are not there yet. Many economist's believe the Bank of England are going to be playing a very dangerous game in terms of raising interest rates in period of fragile economic recovery, one that could backfire spectacularly if consumers and businesses pull back from spending.

It is quite remarkable that only 4 months after the Bank of England seemed to be considering further quantitative easing that they are now talking about interest rate rises.