Loan rates on hold as inflation falls to 1.5%

A ferocious price war among retailers sent the government's preferred measure of inflation plunging to its lowest level on record last month, ruling out any chance of an early increase in interest rates.

Cheaper petrol, and the biggest drop in clothing and footwear prices since 1947, pushed inflation excluding mortgages down from 1.8% in May to 1.5%.

The fall in the cost of living took the underlying inflation rate to the very edge of the 1.5%-3.5% band allowed by Gordon Brown.

Any further decline next month would force Sir Eddie George, governor of the Bank of England, to write an open letter outlining what the monetary policy committee intended to do about the undershoot.

The City, which had been clamouring for an increase in rates to choke off the housing market boom, was taken by surprise by the data, and said an increase in borrowing costs had been postponed for at least three months.

"In these uncertain times, today's weak inflation will prob ably reinforce many members of the monetary policy committee's view that they have time to wait and see," said John Butler, economist at HSBC.

The money markets reacted to the news by raising the odds of an early rise in borrowing costs.

Traders are now pricing in a 0.25%increase by the end of the year, taking rates from 4% to 4.25%. As recently as April, concern about the 20% annual increase in housing prices, and a boom in mortgage equity withdrawal, meant borrowing costs were expected to hit 5.5% by year end.

Sharp falls in inflation excluding mortgages in the past two months have brought it down from 2.3% in April, to a level not seen since the measure was first used in 1975. In its most recent inflation report in May, the Bank was predicting that underlying inflation would stay just below the government's 2.5% target for the rest of this year.

However, the Office of National Statistics said the drop had been caused by widespread discounting across the retail sector, cheaper cars, and the impact of better weather this year on seasonal food prices.

Amid reports that the annual summer sales started earlier than usual this year, the ONS said clothing and footwear prices were down 1% on the month, and 5.9% year on year: the sharpest drop on record.

Analysts had already predicted deep discounting in the shops last month, after news of weak underlying sales growth from the British Retail Consortium earlier this week. It reported that year-on-year sales growth slipped to 3.1% in the three months to June, down from 4.1% a month earlier, and well below March's six-month high of 7.5% - suggesting consumers may be tightening their belts.

According to yesterday's retail prices index, firms in the service sector, sheltered from the effects of the recession, are finding it easier to raise prices than retailers selling goods. Services inflation is running at 4.5%, while the price of goods in June was 1.6% lower than a year earlier.

Headline inflation, which includes mortgage interest repayments, also fell in June, to an annual rate of 1%, the ONS said.

The figures also confirmed that Britain's inflation is comfortably the lowest in the European Union. Measured on the internationally comparable harmonised basis, the UK was close to price stability, with an inflation rate of just 0.8%, compared to an EU average of 1.8%.

Despite the benign inflation picture in yesterday's data, some analysts said Sir Eddie would avoid having to write to the chancellor in the months ahead. "It is probable that inflation will accelerate from this point forward," said Matthew Jackson, of Lombard Street Research. "Barring any supply shocks, inflation will trend upwards towards the target by the end of the year."

The Bank of England is due to publish revised forecasts for growth and inflation next month.