The May Inflation Report is markedly more pessimistic about both inflation and growth than in February and confirms that early further interest rate cuts are off the MPC’s agenda:

1. The central projection based on unchanged rates shows CPI inflation at or above 3% for a year, peaking at 3.7% in the fourth quarter. The fan chart suggests a 30% probability of a peak at or above 4%.

2. The central forecast is on target at the two year horizon assuming unchanged rates, having been significantly below (1.77%) in the February Report. Moreover, risks to this forecast are judged to lie on the upside, having been viewed as balanced in February.

3. Annual GDP growth now troughs at 0.9% in the first quarter of 2009 in the central forecast on unchanged rates, compared with a February low of 1.4%. However, a significant rebound is still projected by 2010 – it is unclear why given reduced prospects of interest rate cuts.

4. The GDP fan chart suggests a 15% chance of an annual contraction in the first quarter of 2009. This implies a significant probability of two negative GDP quarters over the next year – perhaps around 30%.

The one silver lining in the Report is that its forecasts are sufficiently pessimistic to create the possibility of favourable economic surprises over coming months.

Today's inflation figures are shocking but should not have come as a complete surprise given recent warning signals. The details show few redeeming features. Eight of the 11 main categories contributed to the increase in the annual headline rate. The only significant negative contributions were from clothing/footwear and transport – the latter mainly reflecting an erratic fall in air fares.

My previous forecast was that inflation would reach the 3.1% letter-writing level in July, peaking at 3.5% in September and remaining above 3% until February 2009. This was at the top end of economists' expectations but now looks too low. A 4% peak now looks plausible if retail energy prices are hiked by a further 20% later this year, as widely expected.

The view that the Bank of England’s Monetary Policy Committee should continue to cut interest rates because a weakening economy will ensure inflation is back below target in two years’ time is questionable, to say the least. For one thing, the MPC’s remit is to hit the target “at all times” – its actions have less effect at short horizons but still have some impact, so it is wrong to focus solely on the two-year-ahead forecast. More importantly, a nonchalant MPC response to a significant and prolonged overshoot risks undermining its inflation-fighting credibility. Inflation expectations are already showing signs of detaching from the target; if firms and workers build a higher trend level of inflation into price- and wage-setting behaviour, the forecast return to 2% or lower two years ahead is unlikely to occur.

In the last Reuters interest rate poll, conducted before the May MPC meeting, New Star was one of only three houses expecting Bank rate to be held at 5.0% for the remainder of 2008. A near-term cut now looks extremely unlikely barring recessionary signals from activity data.

Recent posts have warned that a surprising surge in inflation could put paid to hopes of early further interest rate cuts. A “triple whammy” of bad news this morning suggests this risk may be crystallising:

1. Factory-gate prices jumped 1.4% in April to stand 7.5% higher than a year ago – the largest annual increase since 1985. The “core” annual rise – excluding food, beverages, tobacco and petroleum products – was 4.6%, a 13-year high.

2. Import prices surged a further 1.9% in March, pushing their annual increase up to 10.3% – approaching the peak of 13.7% reached in 1993 following sterling’s expulsion from the ERM. With the effective exchange rate down by 2% since March and world prices of imported commodities continuing to climb, a further rise is certain.

3. Energy supplier Centrica announced a fall in margins in its residential business to below long run target levels, despite price increases in January. It warned that it would “take the necessary action to deliver reasonable margins in the retail business”, supporting forecasts that residential tariffs will rise by at least a further 10% later in 2008.

New projections in Wednesday’s Inflation Report may show annual CPI inflation peaking at close to 4% later this year and remaining at or above the 3.1% letter-writing threshold for six months or more (see here).

While surging world commodity prices have been the key factor driving inflation higher, the impact has been magnified by a 13% fall in the effective exchange rate from a peak last July – equivalent in magnitude to the 1967 devaluation, when Harold Wilson famously claimed “the pound in your pocket” would be unaffected. Many economists have cheered on this decline, arguing it was necessary to “rebalance” the economy away from consumer spending. In a speech in January, Mervyn King talked approvingly of a drop of almost 10% in the effective rate by then, adding helpfully that “ financial markets are pricing in a significant probability of a further decline”.

With the broad money supply M4 having risen 22% more than nominal GDP over the last three years, and the exchange rate sharply weaker, the surprise is that economists should be surprised by current inflationary problems.