Now market fears deflation

The spectre of deflation - falling prices and a stagnant economy - loomed large today when official figures revealed the dramatic scale of price-cutting over Christmas.

The official measure of inflation had its steepest one-month fall since March 1992 and one of the biggest on record.

The sudden slow-down in the cost of living was partly caused by the Government's cut in VAT from 17.5 per cent to 15 per cent, designed to boost spending in the run-up to Christmas.

But the unprecedented high-street discounting through December also contributed to the collapse in the inflation rate.

The headline rate of inflation - the Consumer Prices Index - is expected to carry on falling through 2009 and could go negative by the end of the year. Economists fear that prolonged deflation could make the recession worse because consumers hoard their cash in the hope that prices will fall further.

The Bank of England has already cut its official interest rate to an all-time low of 1.5 per cent to encourage businesses to borrow and consumers to spend.

Today bank shares rallied slightly in the City after yesterday's catastrophic falls that saw two thirds wiped from the value of Royal Bank of Scotland.

RBS shares were up 1.5p at 13.1p, Barclays rose 1.9p to 89.9p, Lloyds were up 0.9p at 65.9p and HSBC were 9p higher at 510p.

However, despite the rally, wholesale nationalisation of RBS was mooted today as senior members of the Government pushed for 100 per cent ownership rather than the 70 per cent the taxpayer currently owns.

Labour former Treasury chief secretary Lord Barnett told peers: "We are in danger of forgetting that this stems from the incompetence, if not much worse, of the very people - the bankers - whom, to some extent, the Government are depending on to run the banks."

Labour former minister Michael Meacher said the first bail-out had not "wholly succeeded" and there could be no guarantee the latest scheme would succeed either.

However, Chancellor Alistair Darling, who admitted that the Government has a regulatory duty, said: "I don't think in the long term [Government] ought to be running banks."