Inflation falls sharply - but less than expected

Heavy discounting on the high street and the reduction in VAT caused the biggest fall in inflation last month since the recession of the early 1990s, official figures revealed today.

The fall in the annual rate of UK inflation - as measured by the Consumer Prices Index (CPI) - fell to 3.1 per cent from 4.1 per cent in December, according to the Office for National Statistics (ONS).

The drop also marked the first time inflation fell in December since records began, said the ONS.

The fall in CPI is less than experts were expecting, with many pencilling in a drop to as low as 2.6 per cent.

But the decrease will heighten fears over deflation as the impending recession is expected to see further falls over the year ahead.

CPI has fallen significantly from a peak of 5.2 per cent last September.

And the Retail Prices Index (RPI) last month fell at its fastest rate in more than 28 years, as house price declines and the recent dramatic interest rate cuts added to the VAT impact.

RPI, which includes mortgage interest payments, plunged to 0.9 per cent in December from 3 per cent the previous month.

The ONS said the cut in VAT had the biggest effect on inflation, knocking 1 per cent off CPI in December, with greater early Christmas discounting adding to the fall.

Two-thirds of retail prices saw the Government's cut in VAT from 17.5 per cent to 15 per cent passed on last month, added the ONS.

Cut-price promotions saw clothing and footwear deflation of 10.3 per cent last month - its lowest level since official records began in January 1997.

More falls in the price of fuel also combined to knock CPI lower, with the annual rate of fuel deflation at 11.2 per cent.

Graeme Leach, chief economist at the Institute of Directors, said: "Inflation is most definitely yesterday's story. Unless the huge stimulus from the VAT reduction, record low interest rates, a falling pound and the collapse in the oil price begin to take effect soon, the UK will be staring deflation in the face."