City sniffs a rate rise as factory costs go up rapidly

Sterling rose sharply on the foreign exchanges yesterday as the City reacted to surging fuel and raw material costs for Britain's manufacturers by shortening the odds on an increase in base rates over the coming months.

At the start of a week that will give the markets a clearer view of the inflation outlook for the economy, yesterday's data showed that the 40% jump in the price of crude over the past 12 months had left industry's basic costs rising at their fastest rate in four and a half years.

Dealers said the figures for producer prices showed there was inflation in the pipeline and that the prospect of the Bank of England tightening policy in response had made the pound more attractive. Rates have been unchanged at 4.75% since August. Sterling rose by almost two cents against a generally weaker US dollar to just under $1.89 and was also up slightly against the euro at €1.4560.

Some analysts said, however, that firms were absorbing much of the increase from dearer fuel and commodities in their profit margins. The figures from the Office for National Statistics showed that while industry's fuel and raw material costs were up by 9.5% on a year earlier, the cost of goods leaving factory gates were up by 2.6%.

"This backs up our view that profit margins are under intense pressure," Ian McCafferty, chief economist at the CBI, said. "Manufacturers are not able to pass on the increase in costs because of a lack of pricing power."

Jonathan Loynes, chief economist at Capital Economics, said the willingness of producers to squeeze margins offered some encouragement. "While raw material prices are still being forced higher by oil prices, there is some evidence that factory gate inflation has peaked and is now falling."

Marc Ostwald, strategist at Monument Securities, said he believed the Bank would be concerned about the sharp rise in input prices. "The data showed that there are still pressures there and there's a limit to which producers can continue to absorb these increases in [input] prices."

Evidence of whether the higher cost of energy is affecting prices in the shops will become clearer with the release of today's consumer prices index and Thursday's figures for retail sales. Economists said there were signs in yesterday's producer prices index that cold snaps in southern Europe had raised imported food prices and that might put upward pressure on consumer prices.

The Bank's influential quarterly inflation report tomorrow coincides with the monthly snapshot of the labour market. Members of the nine-strong monetary policy committee will be concerned by any sign that falling unemployment is leading to pressure for higher wages. Labour accounts for around two-thirds of industry's total costs.

Howard Archer, economist at Global Insight, pointed to the latest study by Incomes Data Services, released yesterday, showing that pay settlements were running at 3.2% in January compared to 3% in December. "We believe that underlying inflationary pressures are significant, and that the eventual next move in interest rates is more likely to be up than down."

The ONS said fuel and raw materials prices for industry rose by 3.4% in January, more than doubling the annual rate of increase from 4.4% in December to 9.5% last month.

Output prices fell by 0.1% last month, following a 0.4% fall in December. Since hitting a nine-year peak of 3.5% in October and December, the annual increase in output prices has fallen back to 2.6%.

Excluding food, beverages, tobacco and petroleum products - considered by analysts a better guide to the underlying trend - the cost of goods leaving factory gates was up 0.2% last month, with the annual rate up from 2.4% to 2.5%.