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A nasty surprise on UK inflation is likely on Tuesday after the Bank of England unexpectedly raised interest rates to 5¼ per cent last week.

The consensus forecast suggests UK consumer price inflation will rise from 2.7 per cent in November to 3.1 per cent in December, the highest since August 1992.

The Bank of England saw the data before their public release so it can say that steps have already been taken to address the overshoot of the 2 per cent inflation target.

However, Mervyn King, the governor of the Bank of England faces the potential embarrassment of having to write a letter to Gordon Brown, the chancellor, to explain why inflation has risen to a 14-year high.

A February rate rise had been widely expected but the decision to move a month earlier has increased uncertainty about the outlook for monetary policy.

Many economists have now revised their forecasts for interest rates higher. Geoffrey Dicks at the Royal Bank of Scotland expects a further rise for rates in May to 5½ per cent, a six-year high. Mr Dicks said inflation should retreat below 2 per cent by the middle of this year and he expects the rate increases to be reversed by the end of 2007 or early in 2008.

But that depends on the next round of wage increases. The Bank of England’s move was widely seen as a clear signal to wage setters that earnings growth must be kept under control. However, those pressing for higher wages will no doubt interpret the latest rise in interest rates and inflation as a justification for more generous settlements.

The headline measure for earnings growth was running at 4.1 per cent in October against the 4.5 per cent that the Bank considers consistent with price stability. The consensus forecast for November’s data, due on Wednesday, is for an increase of 4.2 per cent. The headline measure compares earnings in the latest three months with the same period a year ago, smoothing growth.

However, the breakdown of the latest monthly figures reveals why concern is mounting. Private sector service earnings rose 4.7 per cent in October compared with the same month in 2005 while manufacturing earnings rose by 5.3 per cent.

The key month for pay settlements is January and their effect will not show up until March so policymakers have an anxious wait to see if there is a vicious spiral developing between rising inflation and higher wage growth.

Friday brings December retail sales, expected to show volume growth slowing slightly from 3.2 per cent in November to 3.1 per cent after a mixed Christmas on the high street.

Analysts prefer to look at the three-month period between November and January to judge the High Street’s performance over the festive period, partly because of the timing of sales and holidays.

However, retailers could well have a difficult start to 2007 as their sales end and home owners tighten their belts in response to rising mortgage payments.

In the Eurozone, industrial production in November, due on Monday, is expected to slow from 3.6 per cent year-on-year in October to 3 per cent, mainly due to a weak performance in France. However, survey evidence suggests the Eurozone’s manufacturing sector maintained strong momentum at the end of last year.

The current conditions measure of the ZEW survey of German economic sentiment reached a record high of 63.5 in December so a small fall to 62 is expected for January, due on Tuesday.

The expectations component has been very weak, reflecting concerns about Germany’s VAT rise in the first quarter of this year but some of this pessimism should moderate.

Inflation in the Eurozone in December, due on Wednesday, is expected to remain unrevised from the initial estimate of 1.9 per cent.

The Bank of Canada is expected to keep interest rates on hold at 4.25 per cent on Wednesday.

Expectations that the Bank of Japan will raise its overnight call rate from 0.25 per cent to 0.5 per cent on Thursday have faded somewhat in recent weeks. This is a key event for global investors this week and some analysts think the BoJ will move, helped by a rebound in consumer spending and evidence that the US economy has continued to expand in spite of higher interest rates.

In the US, industrial production data for December, due on Wednesday, is expected to show year-on-year growth slowing from 3.8 per cent in November to 3 per cent. There has been a marked deceleration in output growth since September, when output rose 5.9 per cent year-on-year.

This weak tone is expected to be reflected in the Empire manufacturing survey for January, due on Tuesday, and the Philadelphia Fed manufacturing survey for January, due on Wednesday.

The Federal Reserve’s latest Beige Book which provides a regional snapshot of activity is due on Wednesday. The Beige Book has proved relatively upbeat, underlining policymakers’ key view that the housing slowdown has not spread into the wider economy.

A key measure of housing market activity, the National Association of Home Builders index, also due on Wednesday, has bottomed out in recent months, raising hopes that the property slowdown is moderating.

However, the evidence for that view remains mixed. Housing starts for December, due on Thursday, are expected to decline from 1,588m (annualised) in November to 1,560m. Building permits have also fallen for 10-months in a row and a further decline is expected in December.

December inflation data, due on Thursday, are expected to show the core measure unchanged at 2.6 per cent year-on-year after it hit a 10-year high of 2.9 per cent in September. Some analysts fear the improvement was due partly to aggressive discounting by retailers and car manufacturers and it may prove temporary.

This connects with one of the key issues facing investors in 2007. The Fed is expected to start cutting US interest rates by the spring but the Bank of England’s decision last week is a clear warning that global inflationary pressures could prove more difficult to control than markets currently expect.

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