The pound has fallen sharply on the foreign exchanges after a shock fall in inflation and fears about a renewed slowdown in the economy forced the City to revise its forecasts of an imminent rise in interest rates.

Financial markets responded to the drop in the government's preferred measure of the cost of living from 4.4% to 4% by putting back their estimate of when the Bank of England would start raising interest rates to the autumn. A rise had been forecast for next month.

"These figures should help to sound the death knell for a May rate hike, especially given the current woes on the high street," said Philip Shaw, economist at Investec.

Dealers had assumed higher global commodity prices would push inflation towards 5% over the coming months, forcing Threadneedle Street's monetary policy committee to abandon its policy of holding borrowing costs at their emergency level of 0.5%.

But the City performed a swift U-turn after news of plunging spending in the high street was followed by data from the Office for National Statistics showing that cheaper food, price markdowns for computer games and smaller increases in clothing and shoe prices than in March 2010 had led to the first fall in the annual inflation rate since last July.

Sterling dropped to its lowest level against the euro in more than five months, edging close to rates not seen since March 2010. The euro was worth around 89p by the close of business in the City, with dealers paying little heed to separate ONS figures showing a marked improvement in Britain's trade deficit in February from £7.8bn to £6.8bn, the lowest for a year.

Chris Redfern, senior dealer at Moneycorp, said: "It is going to be a tough summer for sterling, as a UK interest rate hike will now be kept on hold until later this year. The situation for the pound has been made worse by the increase in ECB interest rates, a move that has strengthened the euro."

Despite last month's decline, inflation as measured by the consumer prices index is still double the government's 2% target. Other measures of inflation also recorded falls last month, according to the ONS. The retail prices index, used as the benchmark for most pay deals, showed the annual increase in the cost of living at 5.3%, down from 5.5% in February.

John Hawksworth, chief economist at PwC, said: "Many people feel that the headline consumer price inflation index does not capture the full rate of inflation that they face in their regular, everyday purchases. Our analysis confirms that this is indeed the case with the latest 'everyday inflation' rate being 5.1% in March as compared to a headline CPI rate of 4.0%. With events in the Middle East and elsewhere continuing to push up global oil prices, this differential may continue to grow in the short term."

A breakdown of the ONS data for the CPI showed that so-called "core inflation", which strips out food and energy prices and is closely monitored by the City, eased back from 3.4% to 3.2% in March.

Analysts said there was still inflationary pressure, with the recent increases in oil prices yet to show up in the CPI.

But Andrew Goodwin, senior economic adviser to the Ernst & Young Item Club, said: "These figures represent a massive surprise on the downside and will no doubt be greeted with relief by the majority of the MPC. Indeed, with the MPC having forecast an inflation rate of 4.1% in Q1, for the first time in quite a while their forecast won't be out of date within a couple of months of being published.

"We may still see CPI inflation edge up further over the months ahead, as the effects of further rises in oil prices feed through. But the dreaded 5% rate that we had once feared now looks a fair way off and is unlikely to be realised. That said, this doesn't alter the fact that households will still see a substantial fall in their real incomes throughout this year - this just eases the pressure a little."