Pound surges as King stokes rate rise expectations

Sterling rose strongly against the dollar on the foreign exchanges last night after higher than expected inflation figures and comments from the governor of the Bank of England, Mervyn King, fuelled expectations of an increase in interest rates next month.

The pound rose by three cents against the US currency to more than $1.81 as signs of limited price discounting in the run-up to Christmas coincided with an end to the greenback's week-long rally.

On the measure preferred by the government, the consumer prices index, inflation remained at 1.3% in December, higher than the 1.2% annual increase anticipated by the City.

Inflation on the CPI measure remained well below the government's 2% target, but Mr King said yesterday this would not affect the decision of the Bank's rate-setting monetary policy committee.

Speaking in Birmingham, he said that instead of being slightly above its 2.5% target on the government's old measure (the retail prices index excluding mortgage interest payments), inflation was now under its target using the CPI yardstick. "Does this mean that monetary policy in the coming months will need to be looser under the new target than it was with the old target? The answer is no."

Mr King said the large difference between the two measures could mostly be explained by house price inflation, which is included in the RPI but excluded from the CPI.

The MPC felt house price inflation would slow over the coming two years - its preferred time horizon - bringing the gap between the two inflation measures to about 0.5 of a percentage point, Mr King added. That would be close to their traditional gap caused by the difference in the way each averages price rises.

"So the change in the target is unlikely to have any material impact on the decisions of the monetary policy committee in the near future."

City analysts had believed that retailers were panicked into substantial price discounts in early December as a result of the reluctance of consumers to part with their money. Data from the Office for National Statistics released yesterday, however, showed that price falls in the clothing and footwear sector were smaller in December 2003 than they had been a year earlier, while rising food bills also added to upward pressure on inflation.