Pound soars as City hopes fade for early rate cut

The pound rose to its highest level against the euro in 10 months last night after higher than expected inflation forced the City to reassess its optimism about an early cut in base rates.

Following comments from Mervyn King on Monday in which he outlined both upside and downside risks to inflation, the City responded to news that the annual increase in the cost of living remained at 1.9% last month by pushing sterling through €1.50 against the single currency.

Dealers had expected inflation to edge back to 1.8% in May but data from the Office for National Statistics showed that more expensive food and alcoholic drinks offset the impact of cheaper petrol.

With crude prices rising strongly in recent days to hit $55 a barrel in New York, the City believes any respite for the motorist may be short-lived and that the Bank has started to fret about the possibility that inflation will breach Gordon Brown's 2% target in the coming months.

"The Bank is now clearly concerned about inflation, with the subject broached by BoE governor King last night," said Gavin Redknap, an economist at Standard Chartered.

"In explicitly pointing out that inflation is likely to remain buoyant, King gave notice to the markets that the Bank isn't contemplating cutting rates any time soon," Mr Redknap said.

Following the recent run of downbeat economic news, sentiment in the City had shifted in recent weeks to an August cut in interest rates to coincide with the Bank's quarterly inflation report. Some evidence of weaker consumer demand emerged from the breakdown of the ONS report, which showed clothing and footwear prices unchanged in May compared with rises in the same month last year.

Analysts are now awaiting the summer sales for clues as to the inflation outlook, but said last night that the prospects of a decrease now looked far less certain after the rise in the cost of living, as measured by the consumer prices index, (CPI) remained at an annual 1.9% for the third month.

Howard Archer, chief UK economist at Global Insight, said: "This is a slightly stronger inflation report than expected, with prices picking up in the services sector and core CPI inflation rising.

"While it is unlikely to unduly worry the Bank of England, it will nevertheless probably reinforce their caution about an early cut in interest rates given the risk that growth could pick up over the summer and fuel potential inflationary pressures.

"Certainly, Mr King's comments yesterday suggested that an interest rate cut as soon as August is improbable."

Other measures of inflation showed falls in May. The retail prices index, excluding mortgage interest payments, dropped from 3.2% in April to 2.9% last month, while the all-items retail prices index slipped back from 2.3% to 2.1%. Unlike other measures, the CPI excludes all housing costs, where price pressure has been easing in recent months as a result of the softening of the property market.