Labour hits inflation target for first time

Big bargains in the January sales were a key factor in the latest figures. Diane Coyle and Michael Harrison report

Inflation was on target last month for the first time since Labour won power in May thanks to record price discounts in the new year sales.

The drop in the price of clothing and footwear last month was the biggest since 1947, while the price of household goods such as fridges and furniture recorded the biggest fall since comparable records began in 1956.

The scale of the price discounts in the sales brought the underlying measure of inflation down to its 2.5 per cent target for the first time since the general election. Analysts now believe bargain-hunting by consumers will keep interest rates from climbing any further.

"If you wanted a sign that interest rates have reached their peak, this must be it. There's a certain poetry about these figures," said Simon Briscoe, an economist at Nikko Europe.

Although some experts remained cautious ahead of today's Inflation Report from the Bank of England and official figures for pay growth, the financial markets celebrated the good news on inflation. Gilt prices surged and the pound shed 2.5 pfennigs against the German mark to end at DM2.94.

The underlying inflation rate fell to 2.5 per cent last month from 2.7 per cent in December. The headline rate, which includes mortgage interest payments, fell to 3.3 per cent from 3.6 per cent.

The main downward pressures came from prices for food, clothing and household goods, along with housing costs. Even though some recent mortgage rises were still feeding through, they were smaller than a year ago.

The price of seasonal foods fell by 0.4 per cent, the first January decline since 1972. The decline took the annual inflation rate in this category sharply lower following some big jumps in recent months.

But the most dramatic developments stemmed from the much bigger price cuts in the sales this year than in the past, which accounted for half of the decline in overall inflation. Yesterday's figures for prices in the high street put into context the boom in sales reported by the British Retail Consortium's monthly survey earlier this week, indicating that the soaring turnover was driven by bargains.

The scale of price discounting in clothes and consumer electronics in January has increased virtually every year since 1986 as shoppers have become more bargain-conscious. Clothing prices fell by 6.6 per cent compared with a drop of 4.2 per cent in January 1997, while the fall in household goods prices this year was 3.9 per cent compared with 3.6 per cent last year.

The pattern is now for prices to rise in December and February, but fall by more in January. A similar phenomenon takes place on a smaller scale in the summer sales for clothing.

Adam Cole, an economist at HSBC James Capel, said: "Consumers' guerilla tactics forced retailers to cut prices of clothing and household goods to an extent not seen since the war."

David Walton at Goldman Sachs said: "There is strategic shopping but also strategic selling. Retailers put their prices up before Christmas."

He added: "I'm not convinced consumers have the upper hand. There is no real sign of a margin squeeze in retailing." Mr Walton, who is one of the City analysts most convinced the cost of borrowing will have to climb again, admitted he saw no prospect of this until at least May.

Others were much more confident about the interest rate outlook. John O'Sullivan at NatWest Markets said: "I don't see any danger of inflation straying too far from its target over the next two years."

The one remaining area of concern is potential pay pressure, with many analysts predicting that today's figures for the jobs market will show underlying average earnings growth will climb to 5 per cent because of higher bonuses. Whether pay growth stays that high will depend on how much further unemployment can fall, and, in turn, how sharply the economy slows down as the year progresses.

The subdued picture on inflation was further underscored by a CBI regional trends survey showing that domestic prices fell in most parts of the country over the last four months. The survey also recorded a decline in manufacturing unit costs in all areas.

As expected, the strength of sterling took its toll on exporters with all regions of the country reporting a decline in export prices and all but three regions experiencing a decline in export orders. The sharpest falls were in Northern Ireland, the North and the North-west.

Buoyant domestic demand came to the rescue of most regions, however, with manufacturers in seven out of the eleven areas recording a rise in total orders over the four-month period. Order books were healthiest in East Anglia, the South-west, East Midlands, the North, Scotland and the South-east.

Companies in eight regions expect export orders to fall over the next four months, partly due to currency factors and partly to the Asian economic crisis.