KENNETH CLARKE'S target measure of underlying inflation dropped to a 27-year low of 2 per cent last month, with little sign that continued falls in unemployment are putting upward pressure on the pace of price increases.

The headline rate of inflation fell from 2.4 per cent in August to 2.2 per cent in September, driven by falls in petrol and food prices, according to the Central Statistical Office. This was a bigger drop than City economists expected. The underlying rate was expected to stay at August's 2.3 per cent.

The good news on inflation eased fears that the Chancellor will raise interest rates again before the end of the year. This boosted share and gilt prices, with the FT-SE index of 100 leading London shares rising by 27.5 points to 3,100.5.

Eddie George, the Governor of the Bank of England, said yesterday that the markets were too pessimistic about inflation and that this could be damaging prospects for investment and economic growth by keeping market interest rates too high.

Mr George said the markets were 'overdoing it a bit and exaggerating the likely upward movement in inflation in the industrial countries, including in this country. And they are probably, therefore, exaggerating the likely pace and size of the increase in short- term interest rates that may be needed to keep inflation down.'

Retail prices rose by 0.2 per cent between August and September, in part reflecting recoveries in household goods, clothing and footwear prices after the summer sales. Food prices were subdued by plentiful supplies of seasonal fruit and vegetables and supermarket competition.

The September inflation figures are normally used to update social security benefit payments. Pensions, for example, are likely to rise by 2.2 per cent, compared with a 1.9 per cent rise in the price of a typical pensioner's shopping basket. Income support and housing benefit should rise by 1.8 per cent.

Simon Briscoe, of Warburg Securities, forecast that the Government would need to spend around pounds 800m less on uprating benefits this year than it had planned last November, because inflation had turned out lower than forecast.

The Government will also save money because fewer people will be claiming unemployment benefit than it had planned for. The number of people without work and claiming benefit dropped by 28,000 in September, adjusting for the 30,000 fall normal for the time of year. This took the jobless total to a 33-month low of 2,566,000, more than 400,000 below its peak at the end of 1992. The number of men joining the dole queue rose in September, but the number of women starting to claim benefit fell to a four-year low.

Unemployment fell in all regions of the country, leaving 9.1 per cent of the labour force without work. But the number of vacancies being notified to JobCentres - and the number of vacancies being filled - both fell slightly during the month.

The fall in unemployment has not been matched by the creation of an equivalent number of new jobs. The two official measures of employment - asking companies how many people they employ and asking individuals whether they have work - paint different pictures, so the Employment Department has launched an investigation into the discrepancy. Employers report that they have shed 101,000 jobs since unemployment peaked in the winter of 1992, but the Labour Force Survey of individuals reports the creation of 294,000 jobs during that time.

The gap between the number of unemployed benefit claimants and the number of people who declare themselves unemployed in the Labour Force Survey is also widening as recovery encourages more people to start looking for jobs. On the LFS measure unemployment among men rose by 9,000 between spring and summer this year.

The Employment Department also reported that average weekly earnings rose by an underlying 3.75 per cent in the year to August, unchanged on annual rates in the preceding two months. But the rate of manufacturing earnings growth is estimated to have risen to 4.25 per cent from an original estimate of 4 per cent for the year to July.

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