Rate rise expected as energy costs start to power inflation

The government was yesterday softening up the public for an increase in interest rates as soaring gas and electricity bills pushed the annual rate of inflation to its highest level since Labour arrived in office more than nine years ago.

With prices for domestic energy rising by almost 30% in the past year, the cost of living in the year to June was up by 2.5%, according to the consumer prices index - up from 2.2% in May and a worse outcome than the City had expected.

With unleaded petrol hovering just below £1 a litre, the Treasury said yesterday that it would further delay the annual increase in excise duty to avoid adding more upward pressure to inflation.

Gordon Brown said in the budget that the uprating of duty on petrol would be kept on hold until September, but John Healey, financial secretary to the Treasury, said yesterday the possibility of an increase would be looked at again in the pre-budget report in the autumn. Excise duties have been unchanged since October 2003, a period in which the cost of crude has more than doubled to $75 a barrel.

Ed Balls, the economic secretary to the Treasury, responded swiftly to the news that inflation was running 0.5 points above the government's 2% target. "At this time of global uncertainty it is important that policymakers remain vigilant to the risks and forward-looking in their approach," Mr Balls said. He called on public sector employees to maintain wage discipline and base settlements on the government's 2% inflation target.

The Bank of England's monetary policy committee, which sets interest rates, had expected inflation to rise as a result of increases in energy prices this spring, but sterling rose on the foreign exchanges in the belief that yesterday's data increased the chances of dearer borrowing.

Rates have been left at 4.5% since a quarter-point cut last August, but some economists believe there is a real chance the Bank will tighten policy next month.

The Office for National Statistics said the cost of "fuel and light" was up by 28% in the year to June, the sharpest increase since early 1981. Unlike the early 1980s, however, when overall inflation peaked at 20%, the cost of domestic fuel and power is increasing at more than 10 times the inflation rate. Over the past year, the cost of electricity has increased 25% and gas 35%, the ONS said. It said further increases were to be expected this month and next.

As a result, there were records on all the government's measures of inflation last month. The 2.5% rate on the CPI was the highest since the index began in January 1997, although it was also at that level in September last year. CPI inflation in the UK is higher than the average for the 25 countries in the European Union.

Inflation as measured by the Retail Prices Index excluding mortgage interest payments, the benchmark until the switch to the CPI in 2003, was up from 2.9% to 3.1%, the highest since May 1998. Many pay negotiators still use the all-items RPI as the basis for wage claims, and this showed inflation up from 3% to 3.3% last month, its highest since December 2004.

In the City, opinion was divided on the implications for interest rates. Some analysts said the Bank's monetary policy committee would be keen to prevent an upward spiral in inflation. Others argued that, with unemployment rising, there was little chance of generous pay increases. The reduction in spending power from rising energy costs would have a dampening effect on the economy, they said.

"The MPC's May forecast effectively gave the committee an option to raise rates; we think they will exercise that option in August," said RBS UK economist Geoffrey Dicks. "There is a case for moving in August rather than delaying until the next forecast in three months' time."

Matthew Sharratt, economist at Bank of America, said: "They are a bit of a shock. [But] I don't think they'll be enough to tip the balance of the MPC towards a rate hike as early as August."