King hints at more interest rate cuts

The prospect of further cuts in interest rates loomed larger last night after cheaper foreign holidays and a cooling of Britain's property boom led to an unexpected fall in inflation last month.

Official data showed that the government's preferred measure of the cost of living - the retail prices index excluding mortgages (RPIX) - remained slightly above the Treasury's 2.5% target in June, but fell by 0.1 points for the second month to 2.8%.

Dovish signals from the Bank of England's new governor, Mervyn King, added to City hopes that subsiding inflation could bring further rate cuts.

The inflation figures were known to the Bank's monetary policy committee before last week's cut in borrowing costs to 3.5%, and City analysts - who had been expecting an RPIX rise to 3% - said the drop vindicated the committee's decision.

Nick Verdi, economist with Barclays Capital, said: "With this information, [the Bank] would have known that the outturn for RPIX inflation in the second quarter was going to be 2.9% - somewhat less than the 3.1% figure it envisaged at the time of the May inflation report. That means this data could easily have been part of the reason for the cut."

Mr King hinted yesterday that last week's cut in interest rates to their lowest since January 1955 may not be the last in the current cycle. He told a committee of backbench MPs that inflation was likely to be more volatile in the future, adding that it would probably move below target when the government moves over to the European method of calculating inflation in the autumn.

It is expected that Gordon Brown will set a 2% yardstick for inflation as gauged by the harmonised index of consumer prices (HICP) in this year's pre-Budget report. Yesterday's data from the office for national statistics showed that, on this measure, inflation slid from 1.2% in May to 1.1% in June.

Mr King warned that the economy could be set for a bumpy ride over the next few years as the long debt-fuelled consumer boom peters out.

"Switches in spending between different sectors could mean more volatile inflation in the short run than over the past five years, as domestic demand may not slow at precisely the same speed as external demand picks up," he said. "So the challenge for the MPC is to keep inflation on track to meet the target in the medium term, while coping with possibly somewhat greater volatility of inflation in the short run."

In the City's money markets, dealers were starting to price in a fresh cut in interest rates over the coming months. "Clearly inflation is going back toward the 2.5% target," said Peter Dixon, economist at Commerzbank. "I suspect that recent unwinding of sterling depreciation is going to put more downward pressure on inflation."