CHEAPER foreign holidays and slowing house prices led the underlying rate of inflation to fall unexpectedly in June.

The news vindicated the Bank of England's decision to cut interest rates last week to a 48-year low of 3.5 per cent.

Figures from the Office of National Statistics (ONS) showed that underlying inflation, excluding mortgage interest payments, fell by 0.1 per cent in June to 2.8 per cent - the second consecutive month of decline.

The fall was due to reduced holiday prices, particularly those booked to European destinations - in contrast to the rises seen last June which coincided with the Queen's Golden Jubilee holiday. Economists predict that inflation has peaked, despite the underlying rate of inflation remaining above the Government's 2.5 per cent target for the eighth month in a row.

John Butler, of HSBC, said: "There are signs that the long awaited slowdown in the service sector - or domestically-generated - inflation is starting to materialise.

"The news in the detail suggests that inflation looks to have reached a local peak."

Adding his weight to the view, Bank of England Governor Mervyn King yesterday told MPs on the Treasury select committee that, in the short run, inflation may move from being above to below the 2.5 per cent target.

Before the announcement, economists had predicted inflation would rise to three per cent last month, from 2.9 per cent in May.