UK annual inflation unexpectedly accelerated in February mainly on weak sterling, while retail price inflation reached the lowest since 1960.

Annual inflation increased to 3.2% in February from 3% in the prior month, the Office for National Statistics said in a report on Tuesday. Economists had expected consumer price inflation to ease to 2.6%. Month-on-month, consumer prices were up 0.9%, faster than a 0.3% rise expected by economists.

The largest upward contribution to the annual inflation came from food and non-alcoholic beverages. Other contributors to the increase were recreation and culture, transportation and clothing and footwear. At the same time, the only downward contribution came from housing and household services.

The ONS said the retail price index, that includes housing cost, rose 0.6% in February from the prior month, while economists expected a 0.1% drop. Despite strong negative contributions from housing and motoring expenditure, retail prices remained flat on a yearly basis, the lowest level since 1960. After rising 0.1% in January, economists were looking for an annual fall of 0.7% in February.

The retail price index, excluding mortgage interest payments climbed 2.5% year-on-year, slightly faster than the 2.4% increase seen in January. Commerzbank's economist, Peter Dixon said the mortgage interest payment component of the index stays around 40% below its December 2007 peak and there would be more to come as the latest rate cuts feed through. Economists at Commerzbank continue to look for the RPI to move into the deflationary territory in the coming months.

The government uses RPI for the revisions of tax allowances, state benefits, pensions and many other types of payment.

According to David Kern, Chief Economist at the British Chambers of Commerce, unexpected rise in UK inflation postpones but does not remove the risk of deflation this year. Though the annual increase was partly due to the weakness in sterling, this might also indicate that productive potential in the economy is falling and there remains less spare capacity to exert downward pressure on prices.

As the inflation remained more than one percentage point above the 2% target, Bank of England Governor, Mervyn King was forced to write another open letter to the Chancellor of the Exchequer, Alistair Darling stating reasons for the above target inflation.

King expects sharp decline in CPI inflation since its peak in September to resume in the coming months. He added, It is likely that over the next year CPI inflation will move below target, although the profile of inflation could be volatile, reflecting the reversal of the temporary change in VAT on CPI inflation.

In the Treasury Committee hearing, King said an upside risk seen is the pass-through of the depreciation of sterling into consumer prices. King said the outlook for inflation relative to the target would guide the timing of the return of interest rates to more normal levels.

On March 5, the Bank of England had voted unanimously to reduce the interest rate by 50 basis points to a historical low of 0.5% and to buy assets using central bank reserves. The Inflation Report from BoE had said the economy would contract at an annual rate of 4% by the end of the first half of the year. Inflation is set to slow to 0.5% by the end of next year, forecasts showed.

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