OTTAWA–The increase in thecost of living in Toronto dropped sharply in December to 1.7 per cent, down from 2.3 the previous month, mostly led by falling gasoline prices.

Ontario's inflation rate fell to 1.5 per cent compared with 2.1 per cent in November.

Nationally, the cost of living hit its lowest level in two years last month as falling energy prices continued to drive annual inflation closer to zero.

P.E.I is already at zero while Nova Scotia and New Brunswick recorded price decreases of 0.2 per cent and 0.6 per cent respectively in December over last year.

Statistics Canada says annual inflation dipped to 1.2 per cent in December, a level not seen since January 2007, and almost a full point below November's two-per-cent rate.

On a month-to-month basis, prices were generally 0.7 per cent lower last month than they were in November.

But the big story is that gasoline prices are coming down at a record pace, diving another 25.8 per cent last month after falling 14.4 per cent in November, on an annual basis.

Last month's plunge was the steepest since the government statistical agency began the gas price index in 1949.

"Canadian headline inflation is poised to drop further in the coming months, with an eventual short-term trip into negative inflation terrain ahead," Douglas Porter, a senior economist with BMO Capital Markets, said in an economic note Friday.

"Still, Canada's inflation rate is now more than a full percentage point above the U.S. pace, and outright deflation is much less of a pressing risk here, particularly in light of the weaker loonie and firm wage gains. But even on that front, the rapid weakening in the economy is expected to eventually take a big bite out of any lingering inflation pressures."

As has been the case for the past several months, food prices are now the main driver of rising prices in Canada, increasing 7.3 per cent in December as the cost of buying fresh vegetables jumped 26.9 per cent and bakery and cereal goods swelled 12.4 per cent.

If not for higher food store prices, inflation would already be at zero, Statistics Canada said.

That scenario is likely not far off, however.

The Bank of Canada forecast Thursday that inflation is likely to dip below zero overall in the second and third quarter of this year as food prices start reacting to lower energy and lower prices for such agricultural commodities as wheat.

Still, the central bank said the prospect of deflation – a prolonged and widespread real drop in prices – is "remote."

Of the eight major sub-groups tracked by Statistics Canada, five continued to record increases in prices over the past year, led by food and shelter costs.

Other components showing increases were household furniture and equipment, health and personal care and alcohol and tobacco. Meanwhile, energy, transportation and clothing and footwear fell sharply.

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As well, the Bank of Canada's core inflation rate, which excludes volatile items such as energy and many food products, remained steady at 2.4 per cent last month.

Ironically, 2008 as a whole actually brought a relatively strong increase in the consumer price index, mainly due to the steep build-up in gas prices in the first half of the year and food prices in the second.

Inflation averaged 2.3 per cent in 2008, the agency said, the highest since the 2.8-per-cent rise recorded in 2003.