Inflation rate drops to 2%

The Bank of England faced a growing clamour for a cut in interest rates yesterday after official figures showed inflation fell further below the government's 2.5% target in December.

Cheaper petrol and tough competition on the high street forced down the underlying rate of price rises, excluding mortgages, to 2% from November's 2.2%, marking 21 months in a row that inflation has been below target.

Core inflation pressure remained subdued, with clothing and footwear prices falling by an annual average of 3.8%, the biggest drop since 1949; household goods by 0.9%, the largest decline since 1959; and food prices by 0.3%, the best performance for consumers since 1960.

Last night, the Bank of England governor, Sir Eddie George, played down hopes of significant reductions in rates, saying that although the monetary policy committee was ready to act if the outlook for growth deteriorated, the economy could expect "steady progress" over the next two years.

However, economists said that with inflation likely to fall further in the months ahead, the MPC might be forced to reduce the cost of borrowing soon even if growth remained relatively strong.

"British inflation has now been below 2.5% for 21 consecutive months, largely under buoyant world economic conditions and rising commodity prices," said Philip Shaw, an economist at Investec. "Even if US activity does not collapse, a normalisation of global growth could help this last for a further 18-24 months, presenting the MPC with the prospect of systematic undershooting of the inflation target for a total of almost four years. This would certainly justify the committee bringing down rates at some point."

The figures, published by the Office for National Statistics, showed that over the year as a whole, underlying inflation averaged 2.1%, the lowest figure since records began in 1976 and down from 2.3% in 1999.

Headline inflation, which fell to 2.9% in December from 3.2% in November, edged higher, averaging 3% compared to 1.5% in 1999, due to mortgage rate rises in the first half of the year.

David Walton, an economist at US investment bank Gold man Sachs, said underlying inflation would have been even lower if it had not been for last year's petrol price surge, averaging 1.6% - just above the 1.5% level which triggers an explanatory note from Sir Eddie to the Chancellor, Gordon Brown.

James Shugg, economist at Westpac, said: "This does make the case even more compelling for a rate cut in February. It will be very difficult for the Bank of England's inflation projections to be stuck at 2.5% on a two-year view if they maintain rates at 6%."

Ian Brinkley, senior economist at the TUC, said: "You can nearly always see something that might cause inflation in the future but in this case there's nothing. There's no case for keeping rates as high as they are."

Mr George said that while the US economy might be in for a "bumpy ride" over the next few months, it was likely to continue growing by 2%-3% and that overall world growth, though weaker than last year, would stay above its long term average.

"On that basis the global economic environment should provide a reasonable background for our own economy," said Sir Eddie, although he added that the MPC would react promptly to changing circumstances. "Despite the fact that we left interest rates on hold again last week, we have certainly not gone to sleep!"