May rate rise less certain after UK inflation cools to one-year low

By Andy Bruce and Sarah Young

LONDON (Reuters) - British inflation unexpectedly cooled to a one-year low in March, according to figures that raise some doubts over bets the Bank of England will raise interest rates in May.

Sterling tumbled below $1.42 and British government bond prices shot up after official data on Wednesday showed annual consumer price inflation fell to 2.5 percent from 2.7 percent in February. The figure was well below economists' average expectation in a Reuters poll for it to hold at 2.7 percent.

While good news for consumers who have been squeezed since the 2016 Brexit vote hammered the value of the pound and pushed up the cost of imports, the fall in inflation suggests price pressures may not be as strong as the central bank had thought.

For the first quarter as a whole, annual inflation averaged 2.7 percent -- somewhat below the forecast of 2.92 percent that the BoE made in February.

A firm majority of economists polled by Reuters in the run-up to the data predicted that the Bank would raise interest rates by 0.25 percentage points to 0.75 percent at its May policy meeting.

"We believe (the fall in inflation) will be good news for growth as household real incomes growth accelerates and boosts spending," Scotiabank economist Alan Clarke said. "The flipside is that the market is likely to question the likelihood of BoE rate hikes, both near term and later in the year."

Short sterling futures -- which reflect expectations for British interest rates -- rose sharply after the data, implying a reduced chance of higher interest rates in the months ahead.

Nonetheless, interest rate swaps still price in a roughly two-in-three chance that BoE rates will rise to 0.75 percent next month.

Two-year gilt yields dropped more than 8 basis points to a one-month low of 0.808 percent.

INFLATION SURGE

Inflation jumped in Britain as sterling plunged after June 2016's vote to leave the European Union.

But inflation appears to have peaked in November, when CPI hit 3.1 percent, the highest reading in more than five years.

Sterling has recovered some of its value in recent months and had reached a post-Brexit referendum high of $1.4377 on Tuesday. That should help to ease some of the inflation pressure which has hurt the spending power of many households.

The Office for National Statistics (ONS) said women's clothing prices rose at a slower than usual pace in March.

"Alcohol and tobacco also helped ease inflation pressures, with tobacco duty rises linked to the Budget not appearing this March, thanks to its new autumn billing," ONS head of inflation Mike Hardie said.

But core inflation, which excludes energy, food, alcohol and tobacco prices, fell by a similar amount to the headline data, unexpectedly dropping to 2.3 percent from 2.4 percent.

The fall in inflation means it is highly likely that wage growth in real terms has by now returned.

Overall wage growth in the three months to February was steady at 2.8 percent -- just behind the rate of inflation over the period. The Bank of England expects wages to grow more quickly than inflation later this year.

Junior finance minister Mel Stride told Sky News that the latest inflation figures pointed to a "potential turning point" for real wages.

The ONS figures pointed to less pressure in the pipeline for consumer prices.

Manufacturers increased the prices they charged by 2.4 percent compared with 2.6 percent in February, slightly stronger than the consensus forecast of 2.3 percent but still marking the weakest rate of increase since November 2016.

The ONS also said house prices in February rose by 4.4 percent year-on-year across the United Kingdom as a whole compared with 4.7 percent in January, the weakest increase in seven months.

Prices in London alone contracted by an annual 1.0 percent -- the first drop in the official measure of house prices in the capital since September 2009.

(Reporting by Andy Bruce; Editing by Catherine Evans)