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Inflation expectations in the UK plunged to their lowest level in nine years last month, giving the Bank of England more scope to cut rates aggressively in the new year.
The Bank of England/GfK NOP Inflation Attitudes survey said people expect inflation to average out next year at 2.8%, compared with expectations of 4.4% - a record high of - set in August this year. Last month's figure was the biggest fall since the series began in November 1999.
The survey showed that the respondents thought inflation currently stands at 4.9%, down from 5.4% in the August survey.
Howard Archer, chief UK and European economist at IHS Global Insight, said: "The sharp fall in inflation expectations was clearly influenced by the plunge in oil prices from their July highs, which is particularly evident in significantly lower petrol prices. Respondents are also likely to have been influenced by the ever increasing discounting and sales being seen on the high street as increasingly struggling retailers battle to get consumers' dwindling business."
He added that the inflation expectations could have retreated even further if the survey had been conducted after the cut in VAT to 15%.
This report will give the Bank's monetary policy committee more freedom to continue to cut interest rates as the economic downturn worsens. It kept rates on hold at 5% from April to September for fear of inflation spiralling out of control. However, it has slashed three percentage points off rates over the last three months to leave them standing at 2%.
Consumer-price inflation peaked at a 16 year high of 5.2% in September but dropped to 4.5% in October. Analysts now expect that inflation will fall below the Bank's official target of 2% in 2009.
"Inflation is set to collapse due to a number of different factors, with both main measures entering negative territory for a while. However we are hesitant to label this as a 'true' period of deflation," said Philip Shaw, chief economist at Investec. "Inflation is volatile, not least because of the extent of swings in commodity prices, but also due to factors such as the VAT changes and, for the retail price index, movements in interest rates. We would not term next year as a 'deflationary' year - nor would we be concerned over relatively high inflation in 2010."
He said falling prices are not all bad news. "In particular, one should be aware that factors such as lower VAT and falling energy prices represent a rise in consumer purchasing power."
When asked what would be "best for the economy" - higher interest rates, lower interest rates or no change, 8% of survey respondents said rates should go up, 46% thought rates should go down and 24% thought rates should stay where they are.
Archer said: "Sharply retreating inflation expectations gives the Bank of England further scope to enact another sharp interest rate cut in January, and we expect a reduction of at least 75 basis points from 2% to 1.25%. Indeed, another 100 basis point cut is looking ever more likely as the economic downturn continues to deepen. We expect interest rates to fall to a low of 0.50% in the second quarter of 2009 and then stay there for the rest of the year. However, it is far from inconceivable that interest rates could come all the way down to zero."
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