Mervyn King, governor of the Bank of England, set the stock market ablaze – albeit briefly – with what was interpreted as an indication that the Bank may not raise interest rates this year after all.
Nervous City markets had been pointing to at least one quarter-point rise increase in the cost of borrowing as inflation ran well ahead of the Bank’s two per cent target.
Instead on Tuesday, Mr King pointed out that the economic slowdown the Bank’s interest-setting monetary policy committee believes is necessary to bring inflation back to the target is "already in train".
The stock market, deeply depressed last week, shot ahead, driving the 100-share FTSE Index 120 points higher at one stage, though it later settled back to finish 67.3 points to the good at 5861.9.
Mr King was writing in an open letter to Chancellor Alistair Darling explaining why inflation of 3.3 per cent over the year to May has broken more than a full percentage point above the target. That was up from three per cent in April, after prices as measured by the Consumer Price Index had jumped by 0.65 per cent in a single month.
He warned that inflation is set to rise sharply in the second half of this year, to above four per cent. Despite that, the Bank’s committee is looking to its "normal forecast horizon of around two years" to get it back to the target. "There are good reasons to expect the period of above-target inflation we are experiencing now to be temporary," he wrote.
"It is possible that commodity prices will rise further in the coming months," he wrote. "Oil prices have now been rising for four years.
"But in the absence of further unexpected increases in oil and commodity prices, inflation should peak around the end of the year and begin to fall back towards the two per cent target."
But Mr King also warned "Inflation is likely to remain markedly above the target until well into 2009. I expect, therefore that this will be the first of a sequence of open letters over the next year or so."
In his reply, Chancellor Darling agreed with Mr King’s assessment of the causes and likely future course of the present burst of inflation.
Endorsing the governor’s implied intention not to risk a sharper economic downturn in an effort to bring inflation rapidly back towards two per cent, the Chancellor added: "The Government will continue to support the MPC in the forward-looking decisions it takes, consistent with the Government’s monetary policy objectives as set out in the (Bank’s) remit, namely to maintain price stability and, subject to that, to support the economic policy of the Government, including its objectives for growth and employment".
In Birmingham, Richard Boot, regional manager of the Institute of Directors, West Midlands, pointed out "We are not seeing the double-digit headline inflation of the 19790s. Admittedly, the inflation outlook will get even worse before it gets better, but the real uncertainty is the direction for interest rates."
He added "We can still avoid an interest rate rise, but it is getting a little too close for comfort."
As the stock market delivered its biggest one-day gain since early April, Mike Lenhoff, chief strategist at the stockbroker Brewin Dolphin, pointed to references in Mr King’s letter to the "squeeze on real incomes" as prices rise faster than pay and the "reduced availability of credit".
"Where is the need for an increase in interest rates?" he asked.
"The (stock market) sell-off from May’s peak has left the UK equity market in an oversold condition, but positive news is needed if any rebound is to be sustained."
The inflation numbers from National Statistics showed that while the Government’s chosen measure, CPI, rose by 3.3 per cent over the year to May, the long-running Retail Prices Index, used by many pay bargainers, was up by 4.4 per cent, higher than at any time since July 1992.
The cost of food has risen by 7.8 per cent, up sharply from a 6.9 per cent increase in April, and higher than in any month since September 1990.
Clothing and footwear was the only sector where prices were still falling, down by 3.5 per cent – or by 6.3 per cent as measured by the CPI.