Drop in inflation increases chances of rate cut

The prospects for a cut in interest rates were boosted yesterday by figures showing that inflation had unexpectedly fallen below the Bank of England's target rate last month in spite of a renewed surge in oil prices.

The Office for National Statistics said the consumer price index (CPI) showed an annual rise of just 1.9% for January, the same as a downwardly revised December figure and defying City forecasts of a rise to 2.1%. The 1.9% rate is the first below the Bank's government-set target of 2% since last May and was sufficient to push the pound down half a cent against the dollar.

The ONS said heavy discounting by clothing and furniture retailers, plus a change in how it calculates its figures, outweighed upward effects from air fares and a 1.7p a litre rise in the price of petrol.

Mervyn King, the Bank of England governor, presents the monetary policy committee's (MPC) quarterly inflation forecast today but analysts said it could already be outdated. As the Bank is required to keep inflation at, rather than below, its target, it could now face pressure to cut interest rates from their current 4.5% level to give the economy and inflation a boost.

Alan Castle, an economist at Lehman Brothers, said: "All in all, these figures add downside risk to the Bank of England's central forecast for the CPI to come in at 2.2% in the first quarter of this year."

Holger Schmieding, at Bank of America, agreed. "Contrary to the BoE's expectations, inflation is now again modestly below the 2% target. A further decline in inflation, coupled with mediocre growth, will likely tilt the balance towards further rate cuts ... We continue to look for 25 basis point cuts in May and August 2006, and for stable rates at 4% thereafter," he said.

The economy has grown sluggishly for 18 months and inflation has been subdued despite oil prices doubling. But the Bank is concerned at renewed signs of life in the housing market and is worried that surging gas prices could still push inflation up.

But oil prices could have a downward effect as crude oil prices have fallen sharply in recent weeks to about $60 a barrel after surging to nearly $70 last month.

Jonathan Loynes, of Capital Economics, said he thought there was now a good chance that the MPC could cut interest rates again as soon as next month. "Indeed, it may only have been a reluctance to surprise the markets that stopped the committee from cutting rates [last week]."