JANUARY’s unexpectedly good data put consumer price inflation (CPI) on track to be back at its 2% target, possibly as soon as May. By the end of the year, as last year’s energy shock goes into reverse, it could be as low as 1.5%.

Falling inflation will ease the squeeze on household incomes, which rose a miserable 1.25% in real terms in 2006. Higher debt-servicing costs will restrict consumer spending to another modest year of 2% growth in 2007.

It has been a good week for inflation. On the CPI measure that the monetary policy committee (MPC) targets, inflation fell from 3% in December to 2.7% in January. Petrol prices were the main driver, falling almost 1p a litre in January and 2% from the previous year. The high street was also helpful, with deflation reemerging in January for the first time since August.

Wholesale gas prices have fallen 28.7% in the past year, some of which will be finding its way into lower utility bills in March. Last year’s energy shock is beginning to unravel nicely.

January’s decline in CPI inflation is a “result” in every sense. December is revealed as an upward spike, not as a transition to a higher underlying rate. It all but eliminates the governor of the Bank of England having to write an explanatory letter to the chancellor and comes at an opportune moment in the 2007 pay-bargaining process.

Over the next two months inflation is not likely to change to any great extent. Petrol prices are down again in February but may not fall much further since the oil price has bounced off its January lows. Energy-price inflation is drifting lower but this will be offset by this month’s 100% increase in air-passenger duty.

The budget is an unknown quantity at this stage; an increase in tobacco and alcohol duties is to be expected even if we are spared another rise in fuel duty three months after the increase in the prebudget report.

From April onwards, inflation is likely to fall very sharply. Between March and June last year CPI inflation jumped from 1.8% to 2.5%, most of which came from gas and electricity. With prices set to fall sharply from mid-March, the shock will go into reverse.

We expect CPI inflation to fall as rapidly as it rose last year, getting back to the 2% target by May. It should fall further in the second half of the year and could be as low as 1.5% by December. On the headline retail price inflation (RPI) measure, inflation should be back below 3% by the end of the year.

The Bank is less optimistic and sees CPI inflation bottoming out at about 1.75%. It recognises that energy inflation will fall sharply but assumes that the current strength of demand and a shortage of spare capacity will allow other costs and prices to fill the void.

It remains intent on holding back demand to ensure that competitive pressures reinforce the downward pressure in inflation. This week’s inflation report shows that the MPC is happy for the market to assume one more 25 basis-points hike in interest rates (even if eventually it fails to deliver).

For the UK consumer the decline in inflation is very good news. Over the past year household incomes have been squeezed — initially by rising inflation, more recently by higher mortgage costs as the MPC has responded to the pickup in inflation.

For most households RPI inflation is a better indicator than the CPI of what has happened to their overall cost of living. If we compare the growth in headline earnings of 4% in December with RPI inflation of 4.4%, the squeeze is evident: real earnings fell in the course of 2006, the first time this has happened under the MPC.

Household consumption rose 2% or slightly less in real terms in 2006, a modest improvement on the 1.3% recorded in 2005. Even so, growth of 3.25% in the two years combined was the weakest since 1992-93 when the economy was emerging from recession and is a far cry from the previous experience when consumption rose an average of 3.75% for nine successive years.

Yet consumption growth has still outstripped income. In 2006 household incomes rose less than 4% after tax and a very sluggish 1.25% once inflation is taken into account. On this basis 2006 was the worst year for real income growth since 1985. Even 2% consumption growth required a drop in the household liquid saving ratio to just 1% of disposable income. Only in the Lawson housing boom of the late 1980s has household saving been lower than in the three years since 2004.

Given how weak real income growth was in 2006, the outlook is for an improvement this year. There is still a great deal of uncertainty about exactly what is happening to wage settlements but, since RPI inflation has doubled in the past year, it would be a surprise if settlements were not to come in higher than a year ago when the median was 3%. Early reports suggest a modest pickup to 3.5% in the three months to January.

With earnings being boosted by another strong City bonus season, headline earnings growth is likely to reach 4½%, possibly higher in the early months of the year. In combination with falling inflation, this will boost household spending power by one to two percentage points this year.

That is the good news. The downside comes from monetary policy. Household debt has risen far more rapidly than incomes and the debt-income ratio is currently above 150%. The cost of servicing that debt has risen as interest rates have gone up and at the end of 2006 accounted for 9.3% of posttax incomes, higher than in 1998 when rates were 7.5%. Repayment of principal added another 3.1%, making 12.4%.

On our forecast of another 25 basis points on interest rates and the growth in mortgage borrowing slowing to about 6% by the end of 2007, debt-servicing costs will rise another one percentage point in 2007. The overall cost of servicing a mortgage would be the highest since the Lawson boom when Miras (mortgage interest relief at source) was still available. For heavily indebted households any relief obtained through higher wages and falling inflation is likely to be cancelled out on the mortgage front.

A big unknown in forecasting consumer spending is the outlook for saving. From today’s extraordinarily low levels the most likely outlook is that higher interest rates boost saving so that spending grows less rapidly than incomes. All of this points to another year of modest growth in consumer spending. Our forecast is for an increase close to 2%, below the MPC’s more optimistic assessment of nearer 3% and, for a third successive year, below the growth of gross domestic product (GDP). January’s slump in retail sales is a salutary reminder that, for most households, cash remains scarce.

For years it seemed that growth in the economy as a whole reflected the strength of consumer demand.

How is it that the economy is growing at a reasonable rate (2.7% last year and another 2.7% on our forecast for 2007) without much help from the consumer? And, since consumer spending is acting as a drag on output, why is consumer inflation as high as it is?

The answer to both questions lies in what is happening to company spending. Business investment is now the most rapidly growing component of demand. We estimate it rose 6% last year and forecast another 5%-6% increase in 2007. It is the strength of corporate spending, across a wide range of activities, that is driving GDP and allowing prices to rise as rapidly as they are.

In this context “consumer” price inflation is perhaps a misnomer. Inflation at present is not caused primarily by consumer demand, but the costs are still borne by the consumer. Household spending is in effect being crowded out by company spending and consumer price inflation is the instrument that has made this happen.

In 2007 the consumer will still be crowded out although, with inflation falling, it will be higher interest rates that keep our spending under lock and key.

Geoffrey Dicks is the chief UK economist at RBS Global Banking & Markets

David Smith is away