The City had expected the inflation rate to remain steady or even inch up slightly. The unexpected drop, from 3.9 per cent in June, reflected the dramatic effect that the recession is having on the pricing policies of retailers and service-providers.
The Treasury greeted the fall in inflation by ruling out any change in government policy on the economy, reasserting the 'Tina' principle laid down by Margaret Thatcher - 'There is no alternative'.
'We must stick to the policies which the Chancellor set out,' said Anthony Nelson, Economic Secretary to the Treasury, as Norman Lamont began his annual holiday in Tuscany. 'The permanent defeat of inflation is the best possible basis for improved competitiveness and lasting growth in output and jobs,' Mr Nelson added.
A Treasury official called the figures 'very good' and predicted a further easing of the inflation rate when even lower factory-gate inflation rates and reduced average earnings feed into the retail price index in the months ahead.
Earlier this week, the Central Statistical Office said the core rate of factory- gate inflation fell to 2.8 per cent - the lowest since the late 1960s. The underlying rise in average weekly earnings eased to 6 per cent in the year to June, the lowest for 25 years.
During July prices fell by 0.4 per cent, led by a sharp fall in seasonal food prices of almost 10 per cent. There was also a 4 per cent slide in prices for clothing and footwear - the steepest drop for any July since 1914 - which reflected extended summer price discounts.
Prices for household goods fell by 1.3 per cent, the largest decline for July since 1956. Only certain lines of insurance, as well as DIY products and pub beer exerted significant upward pressure on prices last month.
Last July, a fall in mortgage rates caused a 0.2 per cent drop in the retail price index. Prices needed to drop by the same amount just to hold steady the annual rate of inflation - the rise over the year to this July. Instead, they fell by more.
However, some upward pressure on prices may resume in August from a rebound in clothing and footwear prices and further rises in pub beer. But the rises are likely to be modest and should be offset by falls in other prices such as gas.
The underlying annual inflation rate, which excludes the impact of mortgage interest rates, dropped to 4.4 per cent last month after a 0.2 per cent decline in prices during July, the sharpest monthly fall since 1975. In June the rate stood at 4.8 per cent. Although the overall July rate of 3.7 per cent compares favourably with an average of 4.5 per cent for the European Community it still stands above the German rate of 3.3 per cent. Other leading industrial countries such as the US, Japan, France and Canada, also boast lower inflation rates.
Further evidence also emerged yesterday that inflation in services, which has lagged behind the inflation rate for goods because of less intense foreign competition, was being subdued by high interest rates and recession.
The Bank of England estimated that last month service price inflation was 7.6 per cent, down from 8.6 per cent in April and 9.7 per cent in January. Nevertheless, service price inflation still has some way to go before it catches up with the subdued rate for goods, which the Bank put at just 3.3 per cent.
In spite of the clamour from business and industry for a cut in interest rates, ministers saw the fall in inflation as justification of their hard squeeze on the
The figures strengthened the opinion of many Tory backbenchers who oppose devaluation of sterling to reduce interest rates. In spite of this week's further rise in unemployment, John Major and Mr Lamont are under no immediate political pressure to change course.
Gordon Brown, Labour's shadow Chancellor, attacked the Government for refusing to listen to the demands for action to bring the economy out of recession more quickly. He warned that Labour would intensify its campaign next week for Britain to use its EC presidency for a European-wide revival. Liz Lynne, for the Liberal Democrats, said there was 'pain but little gain' from the Government's economic policies.
The inflation figures sent share prices sharply higher but failed to provide any comfort for the pound, which remained pinned to the floor of the European exchange rate mechanism.
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