Deflation fears as living costs hit 49-year low

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A smaller-than-expected drop in inflation today failed to ease fears that the UK could soon be in the grip of deflation.

Office for National Statistics (ONS) data revealed a fall in the Consumer Prices Index (CPI) to 3 per cent in January from 3.1 per cent in December, which was far lower than experts had predicted.

But the Retail Prices Index (RPI) measure of inflation - used in most wage settlement negotiations in the UK - plunged to its lowest level in nearly 49 years last month, at 0.1 per cent in January from 0.9 per cent in December.

And there are fears that both RPI and CPI could slump into negative territory over the year ahead, sparking fears for the economy.

Economists were surprised that today's fall in official CPI inflation was not greater, having pencilled in a drop to around 2.7%.

The ONS figures suggested the Government's move to reduce VAT from 17.5 per cent to 15 per cent in December brought forward discounting on the high street, impacting the January inflation data.

Alcohol prices also rose across beer, wines and spirits, while consumers were likewise faced with higher costs for recreation and culture - such as toys and games and package holidays.

However, CPI has still fallen significantly from the 5.2 per cent peak last September as the recession tightens its grip and experts said deflation fears have not eased after today's surprising data.

Fuel prices continue to fall from last year's peak, plunging at the fastest pace on record in January, while recently announced gas and electricity bill reductions are also set to pull inflation lower.

Jonathan Loynes at Capital Economics said: "January's UK CPI figures revealed a smaller drop in inflation than expected, but don't preclude a further fall to zero and beyond over the coming months."

"The pressure on key high street goods prices is still strongly downwards and with these pressures set to intensify as consumer spending weakens further, and food and energy price inflation set to fall considerably further, we still expect CPI inflation to turn negative in the late summer/autumn," he added.

The further fall in RPI will be seen as key given the current round of private sector wage negotiations.

Investec economist David Page said wage growth is going to slow "quite markedly" this year, impacted also by high levels of unemployment.

But he said wages were not expected to fall year-on-year even if RPI turns negative.

"It will be very hard for firms to push through wages growth at a lower level than 1 per cent or 2 per cent," he said.

The Bank of England warned in a grim quarterly forecast last week that the UK would only narrowly avoid deflation.

It believes CPI will reach as low as 0.5 per cent this year and remain well below its 2 per cent target until 2012, even with interest rates cut further from their already historic low of 1 per cent.

The threat of deflation is a major concern for the economy, given than it encourages businesses and consumers to defer spending amid expectations that prices will fall further.

Mervyn King, Governor of the Bank, also hinted that policymakers would imminently resort to quantitative easing tactics - where money supply is increased - alongside rate cuts to ward off deflation.

Minutes of the Monetary Policy Committee's February rates meeting are due out tomorrow and may also shed further light on the extent and timing of further rate cuts and any move to adopt "unconventional" tools.