As foreshadowed in a post two weeks ago, December inflation numbers again surprised unfavourably, with the headline CPI rate jumping to 2.9% from 1.9% in November. This confirms the earlier forecast of a rise above 3% in early 2010, necessitating a sixth explanatory letter from Bank of England Governor Mervyn King to the Chancellor.

The previously-targeted inflation measure, the RPI excluding mortgage interest payments (RPIX), rose to 3.8% last month – this would already have triggered a letter under former rules, requiring explanation of a deviation of more than one percentage point from 2.5%.

The annual rate of change figures for last month are the first since November 2008 not to be distorted by the December 2008 VAT cut. They show headline CPI inflation far above the 2% target, with the bulk of the deviation due to "core" trends – the CPI excluding energy, food, alcohol and tobacco rose an annual 2.8% last month. The Bank of England's forecasts in early 2009 implied that core inflation would by now have fallen beneath 1% under the influence of the mythical "output gap". The impact of economic slack on price trends, however, has been swamped by pass-through of higher import costs due to the 27% fall in the effective exchange rate between July 2007 and March 2009 – a plunge actively promoted by Bank policy-makers.

The November Inflation Report predicted that CPI inflation would average 2.7% in the first quarter of 2010; this forecast will need to be raised significantly in the forthcoming February Report. On the conservative assumption that December's unfavourable surprise partly reflected firms adjusting prices in advance of the return of the standard VAT rate to 17.5% in January, CPI inflation may rise to 3.4% in January before falling back in February and March, averaging 3.2% for the quarter.

The pick-up in RPI inflation is proving even sharper than forecast last summer, partly because house prices have recovered more strongly than assumed. From 2.8% in December, the headline rate may reach 4-5% this spring. Historically, rising RPI inflation has had a negative impact on the poll position of the governing party – see previous post.

Governor King will be able to explain the January move in CPI inflation above 3% as the result of the VAT reversal. The persistent and significant divergence of core inflation from the 2% target, however, is more troubling and casts doubt on the sustainability of the current policy stance.

In the November Inflation Report, the two-year-ahead modal CPI inflation forecast based on an unchanged Bank rate and £200 billion of asset purchases was 2.35% – the furthest above target in the MPC's history. The Bank argued that it was justified in setting policy "too loose" for the medium term because inflation would fall significantly below 2% in the interim. Such an undershoot is now unlikely, implying that the MPC must advance its timetable for tightening if a destabilising rise in inflationary expectations is to be avoided.