Pressure for a rise in interest rates eased significantly yesterday, sending the pound down sharply against the US dollar and European currencies.
Behind the fall were suprising government figures showing that the annual rate of inflation did not move last month. The 3.5 per cent year-on-year figure shocked the markets, which had been expecting a steeper rise.
Coming after fresh evidence of subdued wage inflation, the figures were seen as a further blow to the Governor of the Bank of England, Eddie George, in his tussle with the Chancellor, Kenneth Clarke, over interest rates.
The pound fell 1.5 cents against the dollar to $1.5337 and by two pfennigs against the mark to DM2.2654. The trade-weighted index ended at 84.3, a fall of six-tenths of a point.
The Treasury welcomed the figures as signs that inflationary pressures were being contained. Headline inflation has been under 4 per cent for 38 months, the longest sustained period since the war.
Headline and underlying inflation stayed at 3.5 per cent and 2.8 per cent in July, confounding market expectations of a rise, and delivering the Government a welcome fillip after the setback of the first rise in unemployment in two years.
"Eddie George's guns have been comprehensively spiked by these numbers," Ian Shepherdson, economist at HSBC Markets, said. The gilts market took the same view, with the September future initially rising half a point as fears of interest rate increases receded.
The annual rates of headline and underlying inflation (excluding mortage interest payments) had been expected to rise to 3.7 and 3 per cent respectively because of the effect of heavy discounting in last year's summer sales.
These had resulted in a sharp decline of 0.5 per cent in the retail price index compared with its level in June 1994, a fall the City did not think could be matched this year.
But the markets were wrong: the retail price index did drop back in July, by 0.5 per cent, leaving the annual rate of inflation unchanged. The monthly decline in the retail price index, excluding mortgage interest payments, was the largest in the 20 years the series has been compiled.
However, inflation is still generally expected to pick up in the autumn as particularly favourable influences such as lower than usual seasonal food prices go into reverse.
Seasonal food, which had shown only modest declines at the same time of year in 1994, fell 7 per cent on the month, following an even bigger decline in June. A fall in potato prices as new potatoes came into the stores accounted alone for a fifth of the monthly decline in the all-items index.
The drought is expected to make the usual increase in seasonal food prices in August worse. The hot weather which has helped to bring down prices could exact its own price with a sharp rebound in seasonal food inflation.
There is also doubt about the continuing capacity of retailers to absorb the higher prices being charged by manufacturers. Earlier in the week it was revealed that factory gate inflation had jumped unexpectedly from 4.2 to 4.5 per cent in July.
Retailers certainly took it on the chin in the summer sales. The most startling revelation from the figures was a 4.6 per cent monthly decline in clothing and footwear. This was larger even than the 4.2 per cent fall last July.