By Claire West

Following three successive stagnant months, the rate of inflation is once again on the rise in the UK with the headline consumer price index hitting 3.2% in October.

The consensus market forecast had been for the rate to remain at 3.1%, outside of the Bank of England’s 1.0% - 3.0% target range, requiring the Governor, Mervyn King, to write an explanatory letter to the Chancellor. Last week’s Quarterly Inflation Report had prepared the market for another high number as the comments were noticeably more hawkish than back in August. However, by exceeding forecasts demand for the pound has been lifted as the market prices in even less chance of the Bank extending quantitative easing in the short term.

Duncan Higgins, senior analyst at Caxton FX says, “Although the rate of decline has been relatively slow, inflation hasn’t actually risen since back in April, so it’s little wonder we saw a reaction from the Bank of England last week. Their forecast that the rate would drop back in the medium term was beginning to lack credibility, as today’s data testifies. The argument for an extension to quantitative easing over the next two months is now looking almost null and void.”

Higgins continues, “It seems premature to be talking about an interest rate rise just yet, but members of the Monetary Policy Committee are likely to be leaning closer to Andrew Sentance than Adam Posen at this stage. With inflation running at these levels just six weeks before the 2.50% VAT jump, the argument for a rise in UK interest rates must be mounting.”

Higgins adds, “With sterling already at €1.18 this latest data could be the catalyst to take the pound up through its recent highs. Coupled with the attention that Ireland’s debt crisis is receiving and sterling looks set to continue its upward trend in the short term.”

The pound has also found some support against the US dollar to reach $1.6050 but the price looks vulnerable as the risk on environment deteriorates.