Inflation is still above the target of 2% Consumer price inflation dropped sharply in December to an annual rate of 3.1% from November's figure of 4.1%. The biggest factor was the cut in VAT from 17.5% to 15%, announced in the pre-Budget report on 24 November, the Office for National Statistics said. But high food, gas and electricity prices prevented the rate from falling as fast as economists had predicted. The headline Retail Prices Index (RPI) measure fell to 0.9% from November's 3% rate, the biggest fall in 28 years.

RPI takes account of mortgage costs, which also declined following December's cut in interest rates. 'Recession bites' Falling petrol prices and discounting in shops before Christmas also helped reduce the rate of inflation. Please turn on JavaScript. Media requires JavaScript to play. The biggest discounts were in clothing and footwear, with prices down 10.3%. Transport costs also fell as a result of lower petrol and diesel prices, although air fares and coach fares were both up more than they had been in December 2007. BBC chief economics correspondent, Hugh Pym, said: "The VAT cut was the largest contributor to the fall in the inflation rate.

"This will be reversed at the end of this year when the VAT effect 'falls out' of the inflation figures. "The 3.1% annual rate was a bit higher than analysts' expectations, but the scale of the drop from 4.1% should not underplayed. Inflation is certainly heading lower as recession bites." Our correspondent added: "The plunge in the wider RPI rate, from 3% to just 0.9% was dramatic, reflecting the fall in mortgage rates. RPI inflation could well be negative by the middle of this year." There have been so many bills due this month that our careful spending over Christmas has been blown out of the water.

Andrew Smyth, Belfast

The 'squeeze' families The CPI figure is still well above the government's target rate of 2%, but has dropped sharply from the peak of 5.2% in September. Many economists had expected it to fall even further in December, with a consensus of about 2.7%. Despite that, chief financial secretary to the Treasury, Stephen Timms, said: "The reduction in inflation is obviously welcome - a big reduction down to 3.1% - reflecting in particular, as the Office for National Statistics has said this morning, the VAT cut before Christmas. " Deflation risks Food and energy prices are propping up inflation, with both still above their levels from this time last year. But with oil prices so low, gas and electricity prices are expected to fall in the coming months as are food prices. The falling rate of inflation has raised concerns about the prospect of deflation later this year. "Inflation is most definitely yesterday's story," said Graeme Leach, chief economist at the Institute of Directors. "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." Deflation is a problem because whatever stimulus measures are put in place, consumers may be put off making any purchases if they believe that prices will be lower in the future. "The weakness of core inflation [which strips out food and energy costs] and the further downward pressure likely to result from the opening of a large amount of slack in the economy, points to a growing danger of a more fundamental and longer-lasting period of deflation further ahead," said Jonathan Loynes, economist at Capital Economics.



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