Figures heighten deflation fears

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The Government's VAT reduction and heavy pre-Christmas discounting on the high street drove the Consumer Prices Index (CPI) down to 3.1% last month from 4.1% in November - the biggest monthly decline since April 1992, said the Office for National Statistics (ONS).

The drop also marked the first time inflation had fallen in December since records began, according to the ONS. But the fall in CPI was less than experts were expecting, with many pencilling in a drop to as low as 2.6%.

The ONS said while two thirds of retail prices showed the full cut in VAT from 17.5% to 15%, the service sector had barely passed on the reduction.

However, the steep fall in CPI raised concerns that the UK may be heading for deflation, with the impending recession expected to see further falls over the year ahead. CPI has already fallen significantly from a peak of 5.2% 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% in December from 3% the previous month.

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."

Economist Jonathan Loynes, of Capital Economics, said deflation was possible when energy prices also start to respond to the dramatic declines in the cost of crude oil.

The inflation data is already showing signs of weaker demand in the face of a UK recession. Retailers slashed prices more than normal to lure in shoppers, said the ONS.

Cut-price promotions saw clothing and footwear deflation of 10.3% 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%.