Prospect of rate rise recedes as inflation falls back sharply

Inflation dropped back much more sharply than expected last month, thanks largely to tumbling fuel prices.

In a development that will be welcomed with open arms at the Bank of England, inflation on the key consumer prices index measure fell to 2.7 per cent in January from 3 per cent in December. Although still well above the Bank's 2 per cent target, the City had expected a much smaller decline. Inflation on the broad retail prices index measure, which includes housing costs, fell from 4.4 to 4.2 per cent.

The news will ease immediate pressure on the Bank's Monetary Policy Committee (MPC) to raise interest rates again. However, analysts warned it was still too early to rule out further increases in borrowing costs. Philip Shaw, chief economist at Investec, said: "The MPC will continue to identify wage settlements as a potential medium-term inflationary risk. Although indications suggest that the January pay round resulted in only modestly higher settlements, on balance we remain of the view that the MPC will be sufficiently nervous over pay to trigger one more rate increase to 5.5 per cent over the next few months."

The Office for National Statistics, which published the figures, said transport costs accounted for most of the downturn in inflation in January, as fuel prices including petrol fell this year against a rise in 2006. Prices for food, including fruit, bread, meat, milk, cheese and eggs, also fell.

Looking ahead, analysts expect inflation to keep sliding this year. Karen Ward, UK economist at HSBC, said the fall in retail gas prices announced by British Gas last week was likely to be followed by other energy providers, and should cause the contribution from energy prices to fall sharply. "Gas prices are currently contributing around one percentage point to CPI inflation. This contribution will not only diminish but turn negative towards the end of the year," she said.

If inflation deviates more than one percentage point above or below the 2 per cent target, the Bank's Governor, Mervyn King, is required to write to the Chancellor, Gordon Brown, to explain why it is so far off course, and what the MPC intends to do about it. Ms Ward said there was more chance of the Bank having to write the letter for breaching the 1 per cent lower limit than the 3 per cent upper limit.