The latest inflation figures are expected to show that high street Christmas discounts and the VAT reduction are thought to have resulted in another sharp drop in inflation.

Consumer Prices Index (CPI) inflation is expected to have pulled back last month, reaching a low of 2.6% from 4.1% in November, according to experts.

Since the Office for National Statistics (ONS) started recording figures this fall is expected to be one of the biggest monthly moves ever and will only heighten deflationary fears.

As a result of large falls in fuel costs due to lower oil prices, the CPI fell to its lowest level since June in November.

December's ONS figures are thought to show will a significant impact from the Government's VAT decrease from 17.5% to 15% at the beginning of December.

The ONS estimated last month that if passed on fully, the VAT move could wipe off around 1% to 1.3% from CPI.

Pre-Christmas discounting from retailers desperate to lure in shoppers is also likely to have pulled inflation back further towards the Government's 2% target.

While policymakers have been striving to bring inflation back down to target after last year's fuel price bubble, it is now feared that the impending recession could see CPI fall too far below the 2% goal and possibly lead to a period of deflation.

The Bank of England has been handed important new powers in the Government's latest bank rescue package, which could help it in the fight against deflation.

As interest rates - already at a historic low of 1.5% - are expected to come down close to zero, the Bank's Monetary Policy Committee (MPC) will need to look at alternative tools to use.

The Government yesterday announced a new £50 billion fund for the Bank to purchase private sector assets, which could make it easier for businesses to borrow and therefore spend, boosting the economy and easing inflation back up.

Bank governor Mervyn King is likely to flesh out more details on the scheme in a speech.

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