The rise in CPI inflation from 4.5% in August to 5.2% in September was larger than expected here and by the market. The overshoot resulted from a combination of an even bigger impact from energy utility price hikes than allowed for along with a 0.2 percentage point rise in “core” inflation (i.e. excluding energy, food, alcohol and tobacco), from 3.1% to 3.3%. About half of the rise in the core rate is attributable to air fares, which are volatile from month to month.

The alternative RPI measure was slightly less grim, with annual inflation rising by 0.4 rather than 0.7 percentage points on the month to 5.6% – only just above a temporary 5.5% peak reached in February 2011. Those wishing to find a glimmer of hope in the report can cite a lower annual increase in the tax and price index, which also takes into account income tax and national insurance, than in February – 5.3% versus 6.0%.

While today’s upside surprise warrants some forecasting humility, it seems unlikely that CPI inflation will go any higher in October – an energy price hike by Npower (to be followed by EDF Energy in November) should be offset by a favourable motor fuel price base effect while air fare inflation may moderate. A sustained fall should then begin reflecting the VAT unwind, a slowdown in food and energy inflation following recent commodity price stabilisation and some moderation in “core” inflation in lagged response to economic weakness (as suggested by business survey pricing plans – see chart). The expectation here, however, remains that CPI inflation will trough well above the 2% target and may be trending higher again by late 2012.

Fundamentally, inflation reflects monetary conditions with a one- to two-year lag. This year’s awful inflationary experience confirms that monetary loosening was taken too far in 2009, with the MPC failing to correct the error last year. Sir Mervyn King now argues that monetary conditions are restrictive, as demonstrated by an annual contraction in the “old” M4 broad money aggregate, implying a medium-term risk of inflation undershooting the target. However, a broad liquidity measure constructed by Henderson including foreign currency deposits and public sector money-like instruments rose by 4.5% in the year to August – the fastest annual growth since mid 2008. There is a risk that liquidity trends will deteriorate if the Eurozone financial crisis intensifies but the MPC has jumped the gun by launching QE2 now. The hoses, in effect, have been turned on before the fire has started – although Sir Mervyn is doing his best to talk up the coming conflagration.