Fears of higher interest rates recede: Unchanged inflation and an unexpected fall in the growth of earnings trigger optimism in the markets

FEARS that the Bank of England will demand an early rise in interest rates receded yesterday as official figures showed inflation unchanged last month at 2.6 per cent and the growth rate of average earnings slowing unexpectedly.

The sterling futures market rose sharply, taking a fifth of a percentage point off the market's forecast for interest rates at the end of the year. Gilts also moved higher, with the 83 4 per cent due 2004 rising 14 ticks to yield 8.59 per cent. The stock market was more grudging, with the FT-SE index of 100 leading London shares rising 6.2 points to 3,045.8.

The markets were cheered by the average earnings and inflation figures but remained cautious ahead of the speeches of the Chancellor and the Governor of the Bank of England at the Mansion House last night. The Governor said that the first rise in interest rates could still be some way off, while the Chancellor played down the prospect of tax cuts but suggested there was little need for a rate cut to boost recovery.

High street prices rose by 0.3 per cent in May, keeping the inflation rate at the previous month's 2.6 per cent, according to the Central Statistical Office. Several City analysts said that their measures of core inflation, which capture underlying pressure on prices, had fallen unexpectedly.

The Government's preferred measure of underlying inflation - which excludes mortgage interest payments - edged up a little more sharply than expected, from 2.3 to 2.5 per cent. The Government is aiming to keep it between 1 and 4 per cent and to have it between 1 and 2.5 per cent by the end of the Parliament in April 1997.

Seasonal food prices rose more sharply for the time of year than in any year since 1966, with fresh fruit, potatoes and other fresh vegetables all more expensive. But this was offset by an unusually small rise in non-seasonal food prices. Motoring costs rose, as did the price of personal articles such as spectacles, which bounced back after sale reductions.

Average earnings grew by an underlying 3.75 per cent in the year to April, an unexpected fall from March's 4 per cent. The Employment Department said the March earnings figures had been boosted by bonus payments, including those paid to City high-flyers.

Don Smith, of HSBC Greenwell, forecast that average earnings would be growing at the same rate at the end of year. But John Marsland, of UBS, said improvements in the labour market should intensify wage pressures.

Average earnings growth was stable at 4.75 per cent in manufacturing but fell from 4 to 3.75 per cent in the service sector.

The Employment Department said there was no evidence that rising settlements had put upward pressure on the earnings figures despite the fact that a number of surveys have shown the level of pay deals edging upwards.

Settlements included in April's figures included an average 4.5 per cent rise for Lloyds Bank clerical staff, up from 3 per cent last year, and a 2.5 per cent rise for ceramic industry workers, up from 2.25 per cent last year. But Sainsbury and the master bakers both reached lower settlements than last year.

April also included settlements for teachers and NHS workers, showing rises from 1.5 per cent last year to around 3 per cent this.

The CSO's tax and price index shows that workers need rises of about 3 per cent to compensate for higher taxes and higher prices.

Separate figures showed that growth in productivity - output per worker - continues to accelerate, reaching 3.5 per cent in the year to April. This brought about a sharp drop in the rate of growth of unit wage costs from 2.8 per cent in the year to March to 1 per cent.

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