Relief for households – and Bank – as inflation falls sharply

Bank of England's Sir Mervyn King expects CPI to be back around 2 per cent target rate by the end of the year

The Bank of England gained crucial ground in its battle to tame the soaring cost of living yesterday as inflation fell in January to its lowest level for more than a year.

The fourth monthly fall in a row for the consumer prices index leaves the Bank's official inflation benchmark at 3.6 per cent, down from 4.2 per cent in December and the lowest since November 2010. The latest drop – fuelled mainly by the fading impact of last year's VAT increase to 20 per cent – raises hopes of relief for household budgets crushed by four years of wage rises trailing well behind the cost of living.

Barclays Capital's chief economist, Simon Hayes, said: "The sharp drop in inflation that is under way should be welcomed as a sign that the worst of the squeeze is probably behind us... Falling inflation is a small mercy for which UK households can be thankful."

Recent price cuts by the UK's big six energy companies, which all put up their charges last year, will also help drive down inflation in the months ahead. Alongside VAT, petrol costs were a big driver after rising at a far slower pace than a year ago.

But the Bank of England's Governor, Sir Mervyn King, was still obliged to write another letter to the Chancellor, George Osborne, because CPI remains well above the Bank's 2 per cent target. His 14th open letter since April 2007 stressed that inflation should be back to target by the end of 2012 and underlined that risks to growth from the eurozone debt crisis remained the main concern of rate-setters.

The Bank's Monetary Policy Committee voted last week to pump an extra £50bn into the economy through quantitative easing – taking the total amount printed for QE to £325bn – and is expected to lower its growth estimates slightly again today. The Bank's inflation forecasts are also likely to show the rate languishing below its 2 per cent target in two years' time – potentially paving the way for more money-printing. The economy shrank by 0.2 per cent in the final three months of 2011 while job market gloom is expected to worsen this year as unemployment – currently 2.68 million – heads inexorably towards 3 million.

Sir Mervyn wrote that CPI "will continue to fall back to around the target by the end of 2012", although the pace of its decline remains uncertain as tensions in the Middle East over Iran threaten a fresh spike in oil prices. But the broader retail prices index measure also fell back, to 3.9 per cent, and "core" inflation – which strips out more volatile food and energy costs – fell to 2.6 per cent. The Chancellor replied: "Although inflation is now falling as expected, the process of rebalancing (the UK economy) has a long way to go."

Andrew Goodwin, a senior economic adviser at the Ernst & Young Item Club, said: "We've been waiting for these figures in the anticipation that they would help to emphasise the importance of the temporary factors that kept inflation high throughout last year. They didn't disappoint."

Capital Economics' chief UK economist, Vicky Redwood, said: "This time next year, Mervyn King could be getting his pen out to write a letter to explain why inflation is more than 1 per cent below the target."

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