Inflation fall boosts rate cut hope

Hopes that the Bank of England may cut interest rates again to boost the flagging economy rose yesterday after government figures revealed a sharp fall in inflation last month.

Mortgage rates are already at their lowest in 40 years, but with inflation down to 2.2%, well below the Bank's 2.5% target, economists said there was room for a further cut in borrowing costs as soon as September.

"With inflation this low, if growth stays weak, it will be met with further rate cuts," Ciarán Barr, the chief UK economist at Deutsche Bank, said.

A steep fall in the price of potatoes and other seasonal vegetables trimmed 1.8% off food prices last month, which was enough to knock 0.3 percentage points off the annual rate.

The Bank explained its decision earlier this month to cut rates to 5% - a move which caught financial markets on the hop - by pointing to a sharper than expected downturn in the global economy. Economists believe there is little hope of a recovery until the US economy picks up.

Yesterday however, the International Monetary Fund warned that the American economy is in danger of dragging the rest of the world to the brink of recession.

The IMF expressed concern that, "in light of the importance of the US economy to the rest of the world, any prolonged weakness in the United States was likely to be felt elsewhere, and especially in those economies that are highly dependent on the US for exports."

The IMF delivered a shock to the foreign exchange markets, warning that the US trade and investment deficit with the rest of the world was "unsustainable" and there was a risk of a sharp fall in the dollar.

Traders dumped the US currency in favour of the euro, which for the fourth straight trading day recorded strong gains against the greenback. The single currency also performed strongly against sterling with the pound languishing at a five-month low of 63p to the euro.

The pound has fallen 6% against the euro in the last five weeks, good news for manufacturers but bad news for anyone holidaying abroad. It is now worth just below DM3.10, a rate some senior industry figures believe is just about the maximum British firms could live with if the UK were to sign up for the single currency.

"It is ironic that sterling's biggest lurch lower has come during parliament's summer recess and amid a total absence of any EMU debate," said Nick Parsons, a senior currency strategist at Commerzbank in London.

Pro-euro groups will say today that 115,000 jobs have been lost because the government has dragged its feet on deciding whether to join the single currency.

Counting the Cost, a research report by the Britain in Europe group, argues that 10% of British unemployment since January 1999 is the result of the pound's fluctuations against the euro.

The No Campaign, opposing euro entry, yesterday dismissed the research as "bogus".

"It is trite and completely useless to make claims about whether or not the euro is a good idea based on whether the exchange rate has gone up or down in the last two years," a spokesman said.

"The arguments must be based on the long term, not the short term."

As well as lower seasonal food costs, a sharp fall in the price of crude oil last month helped to reduce the annual inflation rate. The petrol and oil index fell 6.9% in the year to July, the biggest fall since the series began in January 1987.

Offsetting cheaper food and fuel were more expensive foreign holidays and higher clothing prices.

Economists said lower headline inflation is likely to reduce wage claims when the autumn round of pay negotiations begins.

"It will send a clear signal to wage bargainers that there is little justification for big pay awards at a time when corporate profitability is already under considerable strain," said Simon Rubinsohn, an economist at Gerrard Limited.