May CPI drop boosts hope inflation has peaked

LONDON (Reuters) - Lower food costs helped British inflation fall slightly faster than expected in May, boosting hopes price growth has peaked and backing the central bank’s view that it will fall back to target within a year.

Fruit rest in trays at a market stall in Leeds, northern England September 15, 2009. REUTERS/Nigel Roddis

The Office for National Statistics said the annual rate of CPI inflation fell to 3.4 percent in May from April’s 17-month high of 3.7 percent. Economists had forecast a fall to 3.5 percent.

The news will offer some small relief to the Bank of England, which was forced to write a public letter last month explaining why inflation had stayed so far above its 2 percent target for so long.

Sterling fell and gilt prices rose as traders reckoned the figures would reduce pressure on the Bank of England to tighten monetary policy this year.

“The May data is likely to mark the beginning of a gradual downward drift in inflation,” said Andrew Goodwin, an economic adviser to accountants Ernst & Young.

“The temporary factors which have kept inflation above 3 percent since the beginning of the year are beginning to fade and the massive amount of spare capacity in the economy is likely to become increasingly influential.”

The decline was driven by a fall in fresh fruit prices -- especially grapes -- as well as slower rises in the price of petrol, alcohol and tobacco than the same month last year.

Food costs in the CPI index were down 0.1 percent on the month and showed their smallest annual rise since February.

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Despite the latest fall, inflation in Britain remains more than twice the rate in the euro zone and has been significantly above target since December.

The Bank has blamed the recent rise on temporary factors -- the weakness of sterling and January’s rise in value-added sales. But minutes of its monthly policy meetings suggest some of its own policymakers are worried inflation may become a more intractable problem.

At the heart of the debate is a calculation of Britain’s output gap -- the amount of slack in the economy which governs how fast it can grow without fuelling price pressures.

Andrew Sentance, one of the hawks on the nine-member monetary policy committee, said this weekend that the recent rise in inflation raised doubts about how much impact spare capacity was having.

Forecasts from Britain’s new fiscal watchdog also suggest the economy is more at risk from inflation than the government had previously thought.

According to the independent Office for Budget Responsibility, Britain’s output gap at the end of 2009 was around 4 percent of GDP, almost two percentage points lower than the previous government’s assumption.

“There is a little bit of comfort from today’s figures,” said Philip Shaw at Investec. “But it doesn’t change the big picture that inflation remains well above target and also that it has been disappointingly high over the past year or so.”

On the month, consumer prices rose 0.2 percent, slightly less than forecast and a third of the 0.6 percent rate recorded in April.

The annual “core” rate of inflation, which excludes volatile food and energy costs, fell to 2.9 percent in May -- its lowest rate since February.

The retail price inflation gauge, used as a basis for some wage deals, fell less than expected to 5.1 percent, although this was still the lowest rate since March.

Housing costs, which have a higher weight in RPI than in CPI, rose by 3.5 percent, their fastest pace since May 2008.

Editing by Patrick Graham