My current projection shows annual consumer price inflation above 3% between July 2008 and January 2009, peaking at 3.5% in September. This is based partly on an assumed further 10% rise in household electricity and gas tariffs. Recent press reports have, however, suggested a much larger rise in retail energy prices.

The chart below shows the CPI component covering “electricity, gas and miscellaneous energy” together with 12-month moving averages of wholesale natural gas and oil prices. The averages remove volatility and seasonal influences and are a reasonable guide to the trend in suppliers' purchasing costs. They have been projected forward assuming prices remain at current seasonally-adjusted levels.

The moving averages peaked in mid 2006 and fell significantly to a trough in the third quarter of 2007. Household tariffs followed, topping in February 2007 and reaching a low last October. Wholesale gas and oil prices have since surged: if current levels are sustained the 12-month moving averages will be 50-60% above their 2006 peaks by early 2009.

The CPI component rose by 11.9% between October and March but is only 1.9% above its February 2007 peak. Recent experience suggests pass-through from wholesale to retail prices of between a quarter and a half. This suggests a further rise in household tariffs of between 10% and 25% will be needed if current wholesale prices are sustained.

A rise of 25% rather than 10% in retail energy prices would result in a mechanical boost of 0.5 percentage points to annual CPI inflation in late 2008 and early 2009. The actual impact would be smaller because the implied squeeze on consumer spending would slow price rises for other goods and services. Even so, the scenario could involve headline inflation peaking at close to 4% and remaining above 3% for as long as nine months, necessitating three explanatory letters.

I am sticking with a 10% figure for the moment, partly on the view that current wholesale prices may not be sustained. Next week’s May Inflation Report will reveal the assumption used by the MPC. Inflation projections could be revised up by more than the market expects, raising doubts about the scope for interest rate cuts.

Earlier in the year I suggested the ECB would be in a position to cut rates by May (for example here). While the economy has slowed as expected, the forecast has been undermined by a further rise in headline inflation, mainly due to soaring food and energy prices.

My ECB-ometer forecasts an “average interest rate recommendation” of the 21 Governing Council members of -0.01% at this week’s meeting. This is well above the -0.125% threshold for a cut and up from -0.05% in April. The increase over the last month reflects a fall in the euro and improved credit market conditions, which have offset further weakness in business surveys and a slowdown in money supply growth.

The chart presents the ECB-ometer’s output in terms of the probability of a rate change. (Previous posts have shown the average interest rate recommendation.) The chances of a rate cut are estimated to have fallen from 40% in March to below 10% this month.

While the model has become less dovish, it continues to suggest a slight easing bias is warranted by incoming data. This is at odds with the policy statement issued after last month’s meeting and raises the possibility that ECB President Trichet will be less hawkish in his remarks tomorrow.

Activity data should deteriorate further over coming months but recent energy price strength will delay a retreat in headline inflation. I am pencilling in a rate cut in the third quarter but it currently looks far from certain.

This week's MPC rate decision is a particularly difficult call. Activity indicators are at levels historically consistent with a quarter- or even half-point Bank rate cut. The near-term inflation outlook remains troubling, however, with the May Inflation Report likely to show a larger and more prolonged overshoot than projected in February. (Commentators often seem to forget that the Committee’s remit is to achieve 2% inflation “at all times”.) Meanwhile, financial markets have calmed significantly and MPC members hope the new Special Liquidity Scheme will contribute to further improvement.

Weighing up these factors, my MPC-ometer suggests a 6-3 vote for unchanged rates this week. A cut is certainly possible but would be dangerous given current inflationary risks. For comparison, the model forecast is close to the 5-4 vote for no change by the Sunday Times Shadow MPC.