Canada’s annual inflation rate in September dropped to its lowest level in 2½ years as gasoline prices staged their biggest monthly retreat on record, Statistics Canada said Friday.

The overall September inflation rate was just 0.7 per cent, matching the rate reported in February and March of 2004. Inflation was 2.1 per cent in August.

Gasoline prices fell more than 17 per cent last month alone.

"A drop of this magnitude has never been recorded since the introduction of gasoline to the CPI basket," the federal agency said.

The effect of cheaper gas was so profound that overall consumer prices fell by 0.5 per cent last month.

'Core' inflation rises

But core prices, which exclude volatile items like gasoline, showed an unexpected rise. Analysts say that could end up threatening the central bank's ability to cut interest rates in 2007.

"If core inflation continues to show this type of momentum, the case for rate cuts becomes that much harder to make," said TD Bank economist David Tulk. 

Statistics Canada said the core inflation rate rose to 1.7 per cent, up from August’s 1.5 per cent as electricity and homeowners' replacement costs rose.

Since the Bank of Canada’s calculation of core inflation ignores the impact of July’s GST cut, its core reading rose to 2.3 per cent — above its expectation of a two per cent core rate.

'Wild gyrations'

"While the wild gyrations in gasoline prices are certainly providing some fireworks in headline inflation news, the big story here is the move in core inflation to above two per cent a lot earlier than the bank expected," said Doug Porter, BMO Capital Markets' senior economist.

The central bank pays particular attention to the core inflation rate on the assumption that any impact from the eight excluded volatile items will be temporary.  

Alberta again had the highest annual overall inflation rate among the provinces. Alberta's CPI was 3.7 per cent higher than it was a year earlier. But most provinces reported rates of less than one per cent.

P.E.I. and New Brunswick reported negative inflation rates.