Consumer price inflation rose to an annual 3.5% in January, in line with the consensus expectation. The figure appears to have been rounded up, since the index levels in January 2009 and January 2010 were 108.7 and 112.4 respectively, implying an increase of 3.4%. The outturn was higher than forecast in a previous post mainly because food price inflation unexpectedly accelerated – British Retail Consortium and producer output price figures had suggested a slowdown.

The rise in the headline rate from 2.9% in December is explained by the return of the standard VAT rate to 17.5%. The Office for National Statistics and the Bank of England have estimated that the cut to 15% in December 2008 reduced the CPI by about 0.7%. Assuming the same reverse effect, the headline rate may have fallen to 2.8% in the absence of the hike. (The 1.7% annual rise in the CPI at constant tax rates is misleading because it assumes that the VAT increase was passed on in full.)

CPI inflation may fall back to about 3% over coming months, partly reflecting vehicle fuel base effects and lower gas prices. The Bank's forecast, however, of a sustained decline to about 1% by early 2011 is no more credible than its projection a year ago that inflation, then 3.1%, would fall to 1.3% by the first quarter of 2010. The Bank is probably continuing to overemphasise the role of the "output gap" in the inflationary process while underestimating upward pressure on tradable goods prices from the low real exchange rate. The forecast also ignores likely further indirect tax hikes after the election while assuming a stabilisation of commodity prices and sterling.

Governor King's latest explanatory letter to the Chancellor refers to monetary policy being set "to keep inflation close to the 2% target in the medium term". The Bank's remit, however, is to achieve 2% "at all times", although allowance is made for temporary departures due to "shocks and disturbances". Governor King suggests that the VAT hike and rising energy prices represent "shocks" but the tax change was known when the Bank made its February 2009 forecast while higher commodity prices were a predictable consequence of global economic recovery.

Interpreting the remit to imply that the target applies only "in the medium term" allows the Bank maximum discretion in setting policy. When such discretion results in a persistent inflation overshoot, however, such as the 2.8% per annum rise in the CPI in the four years to January, there is a risk of expectations diverging from the target. A rise in market and / or survey-based inflation expectations could yet derail the Bank's dovish approach.