Inflation falls to record low

A chastened City was last night forced to abandon predictions of an imminent rise in interest rates after supermarket price wars and cheaper petrol sent the government's favoured measure of inflation tumbling to its lowest level on record.

The odds on a rise in the cost of borrowing at next month's meeting of the Bank of England's monetary policy committee lengthened after the government published data on the cost of living which showed the annual rate of inflation ex cluding mortgages falling from 2.3% to 1.8% in May.

With ferocious competition among retailers keeping the annual inflation rate well below Gordon Brown's 2.5% target, analysts said the Bank was now likely to turn a blind eye to the recent surge in house prices and defer an increase in interest rates from their 38-year-low of 4% until later in the year.

Other measures of inflation underlined the downward trend in price pressure. The office for national statistics said the all-items inflation rate - which includes mortgage interest payments - dropped from 1.5% to 1.1% last month, while the harmonised index of consumer prices, which measures the cost of living across Europe, showed Britain's inflation rate at 0.8%, comfortably the lowest in the EU.

The City had been expecting the MPC to launch a pre-emptive strike against inflation next month following recent data showing house prices rising at their fastest rate since the late 1980s and consumers borrowing at record levels to finance a spending spree.

But it was taken aback by the fall in inflation last month, which was affected by cheaper seasonal food, lower motoring costs, the price war between Fleet Street's tabloid newspapers and the bargains on offer in stores selling clothes, footwear and household goods. Food prices were 0.7% lower last month than a year earlier, motoring expenditure was down by 0.8% and the cost of clothing and footwear was down by 4.9%.

"The figures are significantly better than expected and may call into question whether the MPC will raise interest rates at its July meeting," said Philip Shaw, economist at Investec bank in London. "Clearly there are no inflationary pressures in the near term," he added.

Deborah Read, UK economist at Bank of America, said: "I think it reduces the risk we see of a move [in interest rates] coming through in July. The fact that inflation has dropped does provide them with the time to delay any hikes."

The ONS said inflation fell so sharply because seasonal food prices dropped slightly this May, whereas they had surged a year earlier due to poor weather which damaged crops. Petrol prices fell 0.4% in May from April whereas they rose sharply the previous May. It also said goods inflation fell to -0.9%, the lowest on record, demonstrating the deflationary pressures gripping retailers, who are forced to trim prices. Only sheltered parts of the service sector are seeing sizeable annual price increases. Services inflation is running at 4.5%.

TUC general secretary John Monks said: "We can see no sign of either higher housing prices or consumer demand feeding into the overall inflation rate. With moderate average earnings and pay settlements, we can see no case for an interest rate rise next month."