Poor harvests, high oil prices and demand from emerging markets have pushed food inflation to its highest level for 20 years.

However, a report by Citi entitled European Food Retail: Surviving in a World of Lower Food Inflation, the banking group finds that, while prices are likely to keep rising, food inflation is expected to fall from its current levels - about 4 per cent to 6 per cent according to retailers and in double digits according to Government figures.

James Anstead, a food retail analyst at Citi, wrote: “It wouldn't be surprising to see food inflation at 1 per cent to 3 per cent by the end of 2009.” This is because the cost of raw materials is falling and oil prices, which feed through to the packaging and distribution costs of retailers and suppliers, are also on the way down.

While slower price rises are good for consumers, for retailers things are less rosy. Food inflation and the valuation of the sector run in close parallel, according to the report. “At the moment, retailers are enjoying much higher valuations than the overall stock market. The concern is that, as food inflation starts to come down, those valuations will begin to fall too,” Mr Anstead explained.

Despite the pressures on consumers, sales growth over the past year has been good. Supermarkets are still likely to grow profits, just not as fast, he said. Reports last week showed that food sales dropped by 0.1 per cent in the three months to September, the first fall since records began. This is understandable, Mr Anstead said. “With inflation as high as it is now, people will buy less. It's no coincidence that high inflation has reduced the volumes bought.”

Growth in the food retail sector is also forecast to fall, from 6.6 per cent in 2008 to 5.1 per cent in 2009. In this climate, retailers will be competing aggressively to expand market share.

Investors, who have previously seen the sector as a fairly safe haven, should be cautious. Mr Anstead said: “In the past, every time food inflation has come down it has hurt the value of the sector. We're not predicting apocalypse but it would be a good idea to be careful.”

At present, the only supermarket with a Citi “buy” recommendation is Morrisons, which has increased its market share recently. It suggests holding Tesco and Sainsbury's.

After increasing its market share steadily, Tesco has had a patchy past 12 months, probably due to gains by Morrisons. However, it is launching discount brands and Mr Anstead said: “We believe that some time next year Tesco will start taking market share again.”

As growth in the sector declines next year, retailers will be increasingly keen to attract the customers. For those who are prepared to shop around there are plenty of ways to cut the grocery bill, Mr Anstead said.

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