Inflation plunge lifts rate hopes

Hopes for an early cut in interest rates to accompany a tax-cutting Budget intensified after headline inflation plummeted and the Government's borrowing position improved for the first time this financial year.

"The chances of a cut in December in the wake of the Budget are rising sharply," Roger Bootle, chief economist at HSBC Markets, said.

This was a view shared in the markets, where the short sterling future contract used to speculate on interest rate changes ended the day implying a cut in rates from their current level of 6.75 to 6.55 per cent. Gilts rallied sharply, too, with the December contract rising by almost a point.

But sterling barely came off the all-time low of 82.6 it reached on Wednesday against a basket of currencies, closing at 82.7 on the trade-weighted exchange rate.

Bill Martin, chief economist at UBS, warned that "the gain in inflation could be offset by the weakness in the exchange rate, which must be causing concern in official circles, if not in the Chancellor's mind". He also warned that inflation could rebound in the months ahead.

Headline inflation dropped from 3.9 to 3.2 per cent in October, its lowest for almost a year. The underlying rate of inflation targeted by the Government - which excludes mortgage interest payments - also fell unexpectedly, from 3.1 to 2.9 per cent. Describing the figures as very encouraging, the Treasury said they showed that domestic inflationary pressures remained subdued.

The dramatic fall in the headline rate, the biggest since January 1993, was the result of the sharpest monthly fall in retail prices for any October for 50 years. A reduction in inflation had been widely expected as the effects of the building societies' recent cut in mortgage rates fed through to the index and the impact of last year's rise in interest rates dropped out. However, the size of the fall came as a shock to the City.

So, too, did the decline in the underlying rate, which the markets had been expecting to rise to 3.3 per cent.

Altogether, the net effect of the changes in mortgage rates this year and last contributed two-thirds to the decline in the annual rate of headline inflation. Keen competition in the insurance market - buildings, contents and motor - contributed about a fifth to the fall. Seasonal food prices, which fell sharply in October, were the other main factor driving the annual rate down.

There was clear evidence that retailers, who pushed through margin increases in August and September, had been forced by consumer resistance to cut prices again.

Clothing and footwear, which had risen 3.9 per cent in September, dropped back by 0.2 per cent. Household goods, up 1 per cent last month, also dropped marginally.

The immediate outlook for headline inflation remains affected by that ultimate seasonal factor, the Budget. Last year's had the effect of increasing prices by almost 1 per cent.

Ahead of the Budget, the Chancellor received a welcome fillip when it emerged that the Government repaid pounds 1.3bn of its debt last month, a surprise after months of higher-than-expected borrowing.

A surge in corporation tax receipts due to higher company profits explained the unexpected improvement in the public finances.

David Miles, UK economist at Merrill Lynch, said: "It is a good time of year to come up with impressive figures like this." City analysts said the favourable news on the public finances would make tax cuts expected in the Budget more acceptable to the markets.

However, most still expect this year's PSBR to exceed the pounds 23.6bn forecast by the Treasury in the summer by pounds 3-pounds 5bn. Sean Shepley, an economist at CS First Boston, said: "The Chancellor will still need to persuade people that tax cuts will be sustainable, and he can balance the budget over a reasonable length of time."

The repayment took the public sector borrowing requirement so far this financial year to pounds 18.8bn, compared with pounds 19.6bn during the same period last year.

Excluding privatisation proceeds, which have been negligible this year, the underlying borrowing requirement has improved by pounds 4.5bn to pounds 18.9bn.

Corporation tax revenues, which vary widely from month to month, reached a record pounds 7.3bn last month. So far this financial year they have been 25 per cent higher than last year - less than the 35 per cent improvement pencilled in by the Treasury. Other tax receipts are also falling short of the Chancellor's targets, mainly because inflation has been lower than expected.

Spending has been successfully contained, on the other hand. Departmental spending has risen 3 per cent this year, in line with plans. There have been steeper rises in debt interest payments.