Inflation could be a lot stronger than expected in 2012

Prices in the UK were up 4.2% in December compared to the year before, according to the latest UK consumer price index (CPI) data. That's down from the 4.8% recorded in November, the most rapid month-on-month slowdown since 2008. Retail price index (RPI) inflation also fell, down to 4.8% in December, from 5.2% the previous month.

The figures were in line with market hopes. And while they are still well above the Bank of England's 2% target, it does take some of the pressure off Mervyn King, who expects inflation to return to 2% by the end of this year.

A drop in fuel prices, combined with heavy competition on the high street in the run-up to Christmas (which has also battered the retail sector), were the main drivers of the decline. Clothes, alcohol and cigarettes all saw falling prices.

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It certainly looks as though prices could fall further. The VAT hike drops out of comparisons from next month. Big energy groups are cutting gas and electricity bills. And after supermarket giant Tesco's recent profit warning, a huge supermarket price war could be on the cards.

Good news for the hard-pushed UK consumer? Well, we wouldn't get too excited. With many suggesting the economy is already in recession, wage growth slow, and unemployment picking up, the chances of another credit boom are slim to non-existent.

Worse still, the faster inflation slows, the more excuse the Bank of England has to start fuelling it again, by printing more money. Quantitative easing is at least one of the main reasons why we are suffering a squeeze on living standards just now. Another flood of money at a time when the US dollar in particular is looking like strengthening in 2012 could push down sterling and drive up the cost of raw materials for us all once again.

The Bank of England has proved to be the most effective central bank in the developed world at creating inflation in the face of massively deflationary forces: we wouldn't put it past Mervyn King and team to do it again.

Investors should keep a close eye on developments this year - take a look at our inflation indicators page here.