Surprise drop in inflation prompts hopes of rate cut

The sun was shining on Kenneth Clarke, the Chancellor, yesterday. News of a surprise fall in inflation last month prompted City analysts to predict another cut in interest rates as early as next month.

David Mackie, UK economist at investment bank JP Morgan, said: "Looking at this week's figures, I'm sure the Chancellor can justify in his own mind another quarter point fall in base rates in July."

Yesterday's favourable retail price inflation figures followed others earlier in the week showing lower-than-expected inflation at the factory gate in May, along with stable underlying earnings and a fall in manufacturing output in April.

The headline rate of inflation dropped to 2.2 per cent, the lowest since September 1994, from 2.4 per cent in May. The target measure of inflation, which excludes mortgage interest payments, edged down to 2.8 per cent after sticking at 2.9 per cent for three months.

The tax and price index, the broadest indicator of the cost of living, grew at its slowest rate for more than three years in the year to May. It rose by only 0.7 per cent in 12 months, thanks to the income tax cuts that came into effect in April.

"The outlook for inflation is becoming spectacularly good," said Ian Shepherdson at HSBC Markets, although he thought Mr Clarke might hold out until September before cutting the cost of borrowing again. As sharp increases in the retail prices index last August and September drop out of the 12-month rate, headline inflation should fall further.

The main contributions to last month's decline in the headline rate were lower mortgages and a drop in seasonal food prices. Seasonal foods now cost 0.5 per cent less than a year earlier, having risen significantly earlier in the year. Lower crop yields due to bad weather conditions are likely to take them higher again, the Office for National Statistics warned.

Meat prices rose in May, with increases in lamb and bacon more than offsetting a small fall in beef prices. However, meat made a negative contribution to the year-on-year inflation rate because poultry prices were higher last year.

Clothing and footwear prices were 1.2 per cent lower than a year earlier, matching the lowest rate since July 1953. Summer sales could put further downward pressure on clothes prices.

Household goods, services and personal goods also helped trim the 12- month inflation rate. The rate of increase in prices of services is at its lowest for 10 years.

The main upward pressure came from motoring costs. Second-hand car prices rose, having fallen last May.

The target measure of inflation, the RPI less mortgage interest payments, declined to 2.8 per cent.

It remains above the Government's 2.5 per cent target, but most economists predict that it will decline towards the target level later this year.

Further falls in inflation would bring lower interest rates into prospect. Mr Clarke referred to the absence of any cost pressures when he sprang his surprise quarter-point base rate reduction last week. In his speech at the Mansion House dinner on Wednesday he said that if he could cut interest rates again without jeopardising the inflation targe, he would.

However, many analysts still think demand will be expanding fast enough by the end of the year to require base rate increases next year. "Other indicators such as consumer demand and service industry pay suggest that sustained inflation below 2.5 per cent is unlikely," said Kevin Darlington, UK economist at Hoare Govett.

Financial markets are betting that the level of base rates will start to climb next year. Official figures next week for retail sales and consumer credit in May are expected to confirm the increasing vigour of consumer spending.