Hopes of interest-rate cuts helped to fuel the surge, as figures from the Central Statistical Office showed inflation rising only slightly in July and high street spending falling back after the early start to the summer sales.
The headline rate of inflation rose to 1.4 per cent in July, following what most analysts believe will prove the post-recession trough of 1.2 per cent in June. Retail sales fell 0.2 per cent in July, after a 1.3 per cent rise in June.
Yesterday's rise in the FT-SE 100 index was the largest since 26 January, and was helped by strong gains in the drugs, food manufacturing and retailing sectors. The FT-SE 250 index of shares in medium-sized companies also rose 29 points to close at 3,494.9.
'We are telling investors in Tokyo to sell the Japanese market and buy the UK, and they are listening,' said Nick Knight of Nomura. While it was too early to talk of a wall of Japanese money, he said that overseas investment was tempting with the yen so high. American, European and domestic investors also joined the fray.
Wall Street also forged ahead. Pharmaceutical stocks again led the way, following President Bill Clinton's comments that he intended to phase in cuts in US healthcare spending over a number of years. The Dow Jones index had risen more than 20 points by late business to trade above 3,600.
The euphoria in the equity market did not extend to the currency or gilts markets. Gilts drifted lower as dealers took profits after recent strong rises, but most analysts expect the climb to resume. The pound was little moved in thin trading until a large buy order through an American bank forced it higher in late trading. It closed 1.82 cents higher at dollars 1.5097 and 1.6 pfennigs higher at DM2.5410.
The rise in inflation to 1.4 per cent in July was in line with City forecasts and largely explained by a smaller fall in food prices than in July last year. Seasonal food prices fell less this year than in any July for a decade. A cut in mortgage rates last July also dropped out of the annual comparison.
Household goods, clothing and footwear prices have shown their sharpest falls on record this summer as retailers have discounted aggressively. Clothing and footwear prices were down 3.5 per cent since June, while household goods prices fell 1.2 per cent.
The Government's preferred measure of underlying inflation - which excludes mortgage interest payments - rose from 2.8 to 2.9 per cent, well below the 4 per cent ceiling of the Treasury's target range. Michael Portillo, Chief Secretary to the Treasury, said on Sky television that the City 'knows the Government will meet its inflationary targets'.
Kevin Gardiner, of Warburg Securities, said goods price inflation had accelerated from 2.5 to 2.7 per cent between June and July, but that service price inflation had slowed from 4.8 to 4.7 per cent.
Retail sales volume fell by 0.2 per cent in July, following a 1.3 per cent rise in the previous month as the summer sales got off to an early start. The fall was in line with City expectations and with the Confederation of British Industry's distributive trades survey. Sales were 4.4 per cent up on the same month last year, the biggest annual increase since the year to March 1989.
Household goods recorded their seventh successive monthly increase, and rose 3 per cent between the three months to April and the three months to July. Clothing and footwear sales fell by 1 per cent in the last three months, with food and department store sales showing small increases.
The British Retail Consortium said that high street spending continued to be buoyant so far in August, and warned the Chancellor not to derail the recovery with unnecessary tax increases. Ian Shepherdson of Midland Global Markets said sales appeared to be rising at an underlying rate of about 0.2 per cent a month.
John Marsland of UBS commented: 'We expect underlying inflation to remain well within its target range over the next two years. Against such a benign inflation background, the Chancellor should take the opportunity to cut base rates to 5 per cent by the end of the year, to maintain the momentum of recovery.'
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