Inflation may cause rate rise re-think

Falls in the price of fish, fruit, meat, bread, cereals and vegetables have helped to bring down inflation to 1.9%. The Consumer Price Index (CPI) is the government’s official measure of inflation, and its steep fall from 2.4% in June has caught the City and the Bank by surprise. The rate of inflation has dipped below the government’s target of 2% for the first time since March last year. Cuts in the price of several foods in a price war between supermarkets has had a great influence on the fall. The monthly decrease from 2.4% to 1.9% is the largest biggest single monthly fall since the CPI took over from RPI as the preferred measure of inflation.

The Bank of England will be relieved at the fall as the pressure on it will be eased. Until last week’s stock market falls it was widely expected that the Monetary Policy Committee (MPC) would vote to push up the base rate once again in September, this time to 6%. Then came the turbulence on the stock market in response to fears of a collapse in credit, the basis of which is in the sub-prime market in the US where investment banks have been relying to heavily on lending money to the sub-prime market which has proved unsustainable. Comments circulated that the falling stock market could result in the Bank holding off on a rate rise for fear of tipping the economy into slowdown. Now the low rate of inflation should make the Bank’s decision easier in early September. There is little doubt that the MPC will now leave the rate unchanged at that time.

The level of inflation is, however, expected to pick up again later in the year as the damage to crops caused by floods across the country in the wet summer will result in an uplift in food costs.

Before recent events on the stock market and these inflation figures the Bank had indicated in its quarterly inflation report in August that the base rate would probably have to rise by another quarter point to continue to keep inflation under control.

Another area where prices were down was in furniture where heavy discounting by retailers enticed customers in out of the miserable weather. Clothing and footwear were the only area where prices were up after summer sales didn’t reach the peak of 2006.

The old official measure of inflation, the Retail Prices Index (RPI) includes mortgage interest payments and is more usually used for wage bargaining, was down from 4.4% in June to 3.8% in July.

As the chances of a further rate rise in the near future receded, so sterling fell in response, dipping under two dollars for the first time since mid-June.

Chief UK economist at Global Insight, Howard Archer, said: “This is a massive surprise. Consumer price inflation fell back far more than anyone was expecting in July - including, we strongly suspect, the Bank of England. This will undoubtedly take the wind out of the sails of the MPC hawks, and will boost expectations that interest rates have peaked at 5.75% especially as the current turmoil in global credit and financial markets further dilutes the case for higher interest rates for now at least. Even so, it is premature for the Bank of England to relax on the inflation front. It is likely that inflation in July was brought down by some summer sales starting early, while recently elevated oil prices and possible future rises in food prices as a result of the bad weather could exert upward pressure on inflation over the next few months.”

The lower than expected inflation rate for July was a fillip for shares in London which gained ground after early Tuesday losses. Thus, it was able to continue the recovery, which had begun on Monday, of last week’s huge falls. Shares worldwide plummeted last week as fears of a global credit crunch sent investors into a panic. The collapse of the US subprime mortgage market resulted in lending between banks coming to a virtual halt, effectively cutting blood supply to the financial markets. Central banks around the world had to intervene to pump money into the system in an effort to prevent meltdown. On Monday Goldman Sachs was forced to inject $3bn (£1.54bn) into one of its key hedge funds as its value dived alongside the stock market. Private equity giant Kohlberg Kravis Roberts also warned that the credit crunch may lead to higher costs and lower returns for its buyouts funded by debt. US lender Aegis Mortgage Corp, which is controlled by private equity firm Cerberus Capital Management, yesterday filed for protection from creditors.

The pound’s fall was matched by a big fall against the euro. UK Government bonds were on the increase as traders’ expectations of further interest rate rises sank. Futures trading also showed investors were sharply cutting back their rate hopes. Of all the countries in the G7 group of industrialised nations Britain has the highest base rates. Last week the Bank of England was warning that it may have to increase the cost of borrowing further because of its fears for inflation rising.