Concerns grew today that the recession could push Britain’s economy into the grip of deflation as a key gauge of price pressures showed annual inflation tumbling to the lowest rate since 1960.

Inflation measured by the Retail Price Index (RPI) extended recent sharp falls in January, sliding to an annual rate of just 0.1 per cent, down from 0.9 per cent in December, and compared with a low of minus 0.5 per cent rate registered in March 1960.

The cost of living measured by the RPI dropped by 1.3 per cent in January alone, driven down by falling mortgage interest bills due to the Bank of England’s past cuts in interest rates, as well as further marked falls in fuel prices.

But less aggressive discounting in the January sales by retailers, who had already pushed through drastic reductions before Christmas, meant that overall price falls last month were smaller than the City expected.

This left inflation on both the main official measures still in positive territory, confounding City predictions of a negative rate on the RPI.

The alternative consumer price index (CPI), on which the Bank of England targets an inflation rate of 2 per cent, showed that prices fell by 0.7 per cent last month, leaving the annual inflation rate on this measure running at a still robust annual rate of 3 per cent in January, down only slightly from 3.1 per cent in December.

The CPI shows higher inflation than the popular RPI since it excludes mortgage interest bills and other housing costs such as an element of the RPI which reflects falling house prices. The two gauges also use slightly different means to calculate inflation.

Despite today’s stronger than expected inflation figures, the Bank of England is still expected to push ahead with a further cut in interest rates next month from their present, historic low of 1 per cent.

The Bank is also expected to begin soon a strategy of “quantitative easing” — creating money to purchase assets in an effort to pump up the money supply and jump-start the economy.

Economists said that with RPI inflation now barely positive, it is all but inevitable that it will turn negative in February data released next month. The CPI inflation measure is also expected to plummet over coming months.

Opinion is divided over whether this, too, will end up showing prices dropping year-on-year, although a negative rate is expected by many analysts.

A negative figure for RPI inflation, indicating year-on-year falls in average prices across the economy and in the cost of living, and even a negative figure on the CPI gauge will see the economy experiencing a form of deflation. However, this will remain some way short of the sort of full-blown, Japanese-style deflation feared by economists and policymakers.

Inflation is being driven sharply lower, and towards negative territory, by the unwinding of the huge increases in oil and other fuel prices last year, which have since been followed by a plunge in these costs.

At the same time, the RPI is also under heavy downward pressure as past interest rate cuts feed through into steep falls in mortgage interest costs. Another big downward influence on the inflation measures comes, for the moment, from the Chancellor’s emergency 2 percentage point cut in the rate of VAT.

All three of these big influences on inflation are set to go sharply into reverse next year, however, with fuel prices expected to stabilise or rise; little scope left for further cuts in interest rates that are already close to zero; and the temporary VAT cut due to end. In turn, those effects will all put upward pressure on inflation in 2010, and tend to make this highly volatile — a danger the Bank of England recently highlighted.

The risk of deflation will multiply, however, as the recession deepens and becomes more prolonged, with scarce demand from wary consumers forcing businesses to cut their prices, and rising unemployment meaning scanty pay rises, and perhaps some cuts in wages.

The fear is that a vicious downward spiral can take hold where falling prices lead consumers to delay buying, triggering further price cuts from struggling businesses, and pushing up unemployment as some firms go under.

The Bank’s decision to pursue quantitative easing tactics will be designed to prevent such a scenario becoming a reality. The Bank warned in this month’s quarterly Inflation Report that Britain will teeter of the brink of deflation for much of the next three years.

In the January inflation data out today, plunging oil prices remained a key driving force, with annual fuel price inflation dropping to its lowest since at least 1997, at minus 15.2 per cent.

Average petrol prices last month fell by another 2.9p a litre to 86.3p a litre, the Office for National Statistics said.

But there were a series of unexpected upward pressures on inflation. As well as less generous discounts in January high street sales, other factors included a surge in alcohol prices, which leapt last month at their fastest rate since March 2001. The cost of leisure activities also rose sharply last month.

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