Inflation at five-year low of 2.1%

HEADLINE INFLATION fell to its lowest rate in six years last month, rekindling the hope that the Monetary Policy Committee (MPC) might cut interest rates again.

Retail price inflation reached 1.3 per cent from 1.6 per cent in April its lowest level since June 1993. The target measure of underlying inflation, excluding mortgage costs, fell to 2.1 per cent from 2.4 per cent, its lowest since October 1994. Goods price inflation hit a record low of just 0.9 per cent, although services inflation stuck at 3.3 per cent. Clothes and shoe prices fell 3.2 per cent in the year to May, their weakest since May 1953.

The unexpected good news drove financial markets to revise their view that the quarter point cut in interest rates to 5 per cent last week was the last.

The pound fell sharply - especially against the dollar as US interest rates are expected to rise soon. Its index lost 0.8 points to end at 104.4, and the pound shed more than a cent to reach $1.5971 in London.

Gordon Brown, speaking to the Treasury Select Committee, praised the MPC. "Meeting our inflation target, as we have, is central to the objective of breaking with the boom-and-bust cycles of the past," he said.

Eddie George told a House of Lords Committee the MPC must not take its eyes of the ball. The Governor said: "It would be totally misleading to say that because inflation was less than 2.5 per cent we can forget about it."

Yesterday's figures showed seasonal foods, housing and second hand cars all helping bear down on the headline inflation rate, which is the measure most important in setting pay.

The Engineering Employers' Federation reported yesterday that pay deals in that sector had stabilised at 2.7 per cent. The average has remained around this level since the autumn, although it is now above headline inflation.

Official unemployment and pay figures due today will give fresh clues about the tightness of the jobs market.

Some economists warned the pound could dive, putting upward pressure on import prices, when the Federal Reserve increases US interest rates to a level above the UK's. Stephen Lewis of Monument Derivatives, said: "Funds are then likely to switch, possibly in some size, from sterling to the US dollar."

A survey of fund managers yesterday showed them to be extremely gloomy about prospects for Wall Street and the US economy. The monthly Merrill Lynch Gallup survey showed 94 per cent predicting a higher Federal Funds rate.

However, there are signs of sharp gains in optimism about both Japan and Continental Europe. "The Asian crisis is happening in reverse," said Trevor Greetham, Merrill Lynch's strategist. "Growth is recovering in Japan and Europe, but the US will give up the inflation gains it made earlier."

Mr Greetham predicted US growth would slow as Asia and Europe picked up. The survey showed most of the fund managers surveyed expected just a small increase in US rates.