Surprise fall in inflation

Inflation fell unexpectedly last month, but still remained above the government's 2.5% target, official figures showed today.

The underlying rate of inflation dropped by 0.1% to 2.8%, while the headline rate, which includes mortgage interest payments, was down by 0.1% to 2.9%.

Warm June weather, tempting shoppers out on to the high street, had been expected to keep the underlying rate static or up to 3%. However, the declining cost of foreign holidays, compared with during the Jubilee bank holidays a year ago, brought it down.

There was also a large downward contribution from property, with house prices in June rising less than they had last year.

The news will lend further support to the view that inflation has now peaked, and provide more justification for the Bank of England's decision to cut interest rates to a 48-year low of 3.5% last week.

The recent strength of sterling has also helped to remove the threat of inflation.

John Butler at HSBC said: "There are signs that the long awaited slowdown in service sector - or domestically-generated - inflation is starting to materialise.

"The news in the detail suggests that inflation looks to have reached a local peak."

Adding his weight to the view, the Bank of England governor, Mervyn King, today told MPs on the Treasury select committee that, in the short run, inflation may move from being above to below the 2.5% target.

In a written submission to the committee, Mr King said keeping inflation close to target had been at the expense of the build-up of "significant economic imbalances" between different sectors of the economy.

He said those imbalances would unwind over the next five years but "such switches in spending between different sectors of the economy could mean more volatile inflation in the short run" as domestic demand may not slow at precisely the same speed as external demand picks up.

Earlier, his deputy with responsibility for monetary policy Rachel Lomax voiced concern about debt and the housing market.

"Anyone with my experience is going to be worried about debt ... the current levels of debt and the housing market," she said.

"I think there is a worry about the whole outlook in Europe as well as, as much as, more than, possibly, the States."

There was also a fall in the harmonised index of consumer prices (HICP) to its lowest level since September 2002, as it slipped to 1.1% last month from 1.2% in May.

The measure is used in the eurozone, and is the inflation indicator preferred by the chancellor, Gordon Brown, in preparation for entering the single currency.

HICP saw a large fall from transport, mainly due to the cost of air fares, which rose less than last year.

The Bank of England's inflation target of 2.5% is set to be revised and based on HICP from November.

Britain's stuttering economy was given a boost last week when the Bank heeded industry calls for a cut in interest rates.

Justifying its decision, the Bank pointed to hesitant global economic recovery, adding that action was needed to keep inflation on track in the medium term.

In what was a dramatic first meeting as governor for Mr King, the Bank's rate-setting Monetary Policy Committee reduced the cost of borrowing by a quarter of a percentage point to 3.5%.