The prospects of an interest rate rise in the next few months have dimmed after inflation fell to a five-year low last month.
Official figures showed inflation dropped to 1.2% in September from 1.5% in August as food and fuel prices fell. The easing pace of price rises will take some pressure off households that have been struggling with below-inflation pay rises for years and will be welcomed by homeowners who had been bracing themselves for higher mortgage costs in the new year.
The inflation figure also means the basic state pension will rise by 2.5%, or £2.85 a week, in April, as the government’s “triple lock” guarantees a rise of whichever is the greater out of average earnings, September’s inflation rate or 2.5%.
Financial markets were caught off guard by the fall as City economists had expected a more modest slowdown in consumer price inflation (CPI) to 1.4%. The pound weakened against the euro and the dollar, and yields fell on UK government bonds as traders pushed back bets on when the central bank will start to raise rates from their current record low.
The markets are now pricing in the first rise in borrowing costs for mid-2015. Until now the market consensus had been the early months of next year, though some economists had warned growth was softening and price pressures were benign.
“We have long been expecting the Bank of England to first raise interest rates from 0.5% to 0.75% in February – but it is looking ever more likely that the Bank will delay acting until nearer mid-year,” said Howard Archer, an economist at IHS Global Insight.
“Much will clearly depend on just how well UK growth holds up over the coming weeks and months, as well as how much wages move up in the 2015 pay settlements,” he said.
The Office for National Statistics said stronger post-holiday falls in air fares this year and price moves in electronic goods had helped pull inflation down to its lowest level since September 2009. Food and fuel prices also fell on the year after a supermarket price war and a sharp fall in crude oil prices. Excluding volatile items such as food and fuel, there was still a let-up in price pressures and core inflation stood at 1.5%, down from 1.9% in August.
The retail price index measure of inflation, which includes housing costs and is used to set many pay deals, fell to 2.3% from 2.4% in August.
The Bank has a government-set consumer prices index (CPI) target of 2.0%. If inflation misses that by more than one percentage point on either side, the governor, Mark Carney, must write an open letter to the chancellor, George Osborne, explaining the reasons and what the Bank proposes to do about it.
Samuel Tombs of the Capital Economics thinktank thinks there is a good chance Carney will have to put pen to paper given inflation looks likely to fall further over coming months owing to falling oil prices and pledges from utility companies to freeze prices this winter. Tombs also pointed to separate official figures that showed prices paid and charged by manufacturers continued to fall in September.
“The absence of any major underlying inflationary pressure should still ensure that interest rates rise at a very gradual pace by past standards,” he said.
The Treasury welcomed the fall in inflation as “further evidence that the government’s long-term economic plan is working”, and also highlighted the 2.5% rise in the state pension. “That means around an extra £150 more in the pockets next year of those that have worked hard all their lives,” said a Treasury spokesman.
But some economists noted that the proposed rise in pension payments will leave a disparity between benefits paid to young and old. Martin Beck, senior economic adviser to the EY ITEM Club, said: “September’s inflation rate usually has important ramifications for public finances, as it is used to uprate benefit payments. However, with government policy limiting growth in most working age benefits to 1% next year, the net gain to the exchequer from a lower inflation reading will be limited.
“Pensioners are set to enjoy a relative windfall. With inflation and earnings growth so low, the ‘triple lock’ means that pensions are set to rise much faster than pay or benefits received by younger people.”
Labour pointed out that inflation is still higher than average pay growth, meaning wages continue to fall in real terms.
Catherine McKinnell, the shadow Treasury minister, said real wages had fallen by £1,600 a year since 2010.
“The squeeze on working people continues despite this fall in the rate of inflation. Total pay is rising at just 0.6%, which is half the rate of CPI inflation announced today,” she said.
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