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UK inflation falls as shops discount and VAT hike falls out

• Consumer price index drops from 4.2% in December to 3.6%
• Retail price index falls from 4.8% to 3.9%
Sir Mervyn King still forced to write to chancellor
• Retailers forced into discounting

The squeeze on Britain’s cash-strapped households eased as inflation fell to 3.6%last month – its lowest level for more than a year.

The Office for National Statistics said the consumer price index had declined from 4.2% in December, its lowest level since November 2010, as the impact of George Osborne’s VAT increase dropped out of the annual comparison.

VAT was increased from 17.5% to 20% last year as part of the coalition’s deficit-reduction plan.

Howard Archer, of the consultancy IHS Global Insight, said there should be a fresh decline in February as many shops delayed passing on the VAT increase until the end of the January sales. “Consumer price inflation should fall appreciably further,” he added.

Despite the decline in inflation, Sir Mervyn King, the Bank of England governor, was forced to write another letter to the chancellor explaining why inflation was more than one percentage point above the government’s 2% target.

In his letter, King warned that the economy was still adjusting to life after the credit crunch.

“The unwelcome contribution of sluggish growth and high inflation over the past two years is a reflection of the need for the economy to rebalance following the financial crisis and associated deep recession, together with rises in the costs of energy and imports,” he wrote.

“Although inflation is now falling broadly as expected, the process of rebalancing still has a long way to go. Growth remains weak and unemployment is high.”

With Osborne determined to stick to his policy of austerity after the decision by the Moody’s rating agency to cut the UK’s outlook to negative, the Treasury is relying heavily on the Bank to boost the economy with its £325bn policy of quantitative easing.

But King also used his letter to warn the chancellor that “there is a limit to what monetary policy can achieve when real adjustments are required”.

Osborne replied that monetary policy is “the first line of defence in the face of economic shocks”, and insisted that the government’s deficit reduction strategy had created the room for the Bank to act.

Retailers have been forced into discounting amid tough trading conditions on the high street. Over the past two months, inflation has fallen by 1.2 percentage points.

The ONS said that was a larger decline over two months than at any time since 2008, when Alistair Darling cut VAT as part of his emergency economic rescue package. On the wider retail price index measure, which includes housing costs, inflation fell to 3.9%, from 4.8% in December, it said.

High inflation, and the resulting belt-tightening by workers who have faced declining real incomes, was blamed for much of the shortfall in economic growth in 2011, with GDP expanding by just 0.9%.

Aside from the VAT cut, the ONS said the price of fuels had fallen as had “products bought in restaurants and cafes”, tobacco, and vehicle maintenance and repair.

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