Interest rate pressure eases as inflation falls to lowest on record

The threat of an early rise in interest rates receded yesterday after surprise figures showing that inflation tumbled last month to its lowest since records began in 1975.

The target rate of inflation – the one used by the Bank of England when deciding whether to raise or lower the cost of borrowing – fell from 2.3 per cent in April to 1.8 per cent in May. Meanwhile, the headline inflation rate, which is widely used as a marker for pay deals, fell from 1.5 per cent to 1.1 per cent.

Economists had expected the target inflation rate, which excludes mortgage payments, to come in at about 2 per cent for May and said the bigger than expected drop made a rate increase next month much less likely.

A clearer indication of the Bank's mood will emerge today when it publishes the minutes of the Monetary Policy Committee's last meeting showing how many of its members voted to keep rates on hold earlier this month. City analysts are also awaiting tomorrow's retail sales figures, which will give a further indication of the inflationary pressures building up in the economy.

Philip Shaw, an economist at the London bank Investec, said: "The figures are significantly better than expected and may call into question whether the MPC will raise interest rates at its July meeting."

The economics team at Barclays Capital said the May inflation figures meant that an increase was now probably more likely in August than July. However, it added that a split vote on the MPC when the minutes are published and an increase in retail sales would make it plump for July still.

National Statistics said that falls in seasonal food and petrol prices were behind last month's sharp dip in the inflation rate. Seasonal food prices fell by 1.9 per cent while non-seasonal food prices edged up only marginally compared with a 0.5 per cent increase a year ago. In addition, the sharp increase in petrol prices in May of last year slipped out of the annual calculation. The statistics office also said goods inflation had fallen to minus 0.9 per cent – the lowest on record – providing further evidence of deflationary pressures.

The May figure was a joint low alongside January and November last year and represents the 36th time in the last 38 months that inflation has been below the Bank's target rate of 2.5 per cent. It also takes the targeted measure of inflation – which excludes indirect taxes and mortgage costs – closer to the psychologically important level of 1.5 per cent. If inflation falls below that level then Sir Edward George, the Bank's Governor, must write to the Chancellor explaining why it has missed the target by more than 1 per cent.

The stock market shrugged off the lower than expected inflation figure with the FTSE 100 falling 54.8 points to 4,702.

In the US there was also positive news on inflation. Consumer prices were unchanged in May, and economists now expect the Federal Reserve will wait several more months before considering rate hikes. The Labor Department's retail price index showed prices were 1.2 per cent higher compared with May 2001, close to a 16-year low of 1.1 per cent. In April the figure was 1.6 per cent.

In the eurozone, inflation subsided to the European Central Bank's self-imposed 2 per cent ceiling for the first time this year in May, down from 2.4 per cent in April, Eurostat said.