Stephen Robertson, British Retail Consortium Director General, said, “January’s VAT increase was lost among a huge number of discounts and promotions. We would have expected non-food inflation to be higher because of the VAT rate reversal, but many shops held off passing the extra costs onto their customers.

"Fierce competition, in the face of weakening consumer demand and uncertainty about the recovery, is keeping shop prices down. “Food inflation slowed for the first time since August 2009. It's now only a third of last year’s high. This has largely been driven by a slowdown in fresh food inflation, particularly for meat and milk. But the cost of commodities, such as sugar and coca, has significantly increased in the past year which will put upward pressure on food inflation if it continues."

Mike Watkins, Senior Manager, Retailer Services, Nielsen comments, “With weaker shopper demand after Christmas and many retailers holding back or absorbing the VAT increase, it is no surprise that the shop price inflation is broadly unchanged this month. Many seasonal lines have also come off promotion and this will have impacted some food prices but food retailers are having to work hard to encourage shoppers to spend and there is a continuation of high levels of in-store promotions in January.“

The BRC-Nielsen Shop Price Index reported annual inflation of 2.3% in January, up from 2.2% in December. The marginal increase in overall shop price inflation was driven by the non-food category which reported its highest annual inflation rate since the series began in December 2006, but this is much lower than the Consumer Price Index (CPI). Many retailers held off passing the VAT increase on to consumers in the hope of stimulating demand. As a result, inflation has not risen as fast as we had anticipated. The large number of discounts and promotions meant that the increase in VAT on 1st January was lost among deeper discounts.

Many consumers used VAT returning to 17.5% as an opportunity to bring purchases forward, which helped contribute to the best December retail sales growth reported since December 2005. We may see a further rise in inflation once the VAT reversal has been passed on fully.

Food inflation slowed for the first time since August 2009, driven by slowing fresh food inflation. However, upward pressure from commodity prices could be in the pipeline. The Thomson Reuters/Jefferies CRB Index, which tracks the movements of a basket of commodities, is currently 22% up on a year ago and has increased 10% in the last six months. If commodity prices continue to rise, retailers will face increasing pressure on their cost base in the medium term, which is likely to put pressure on consumer prices. In the short term, retailers are likely to absorb these costs as the outlook for consumer demand remains weak. The output Producer Price Index for food and beverages in December was unchanged from November’s annual inflation rate of 1.8%.

The effective exchange rate for sterling steadily rose during 2009, increasing 9%. However, most of the improvements were made in the first 6 months of 2009, when sterling appreciated 14%. The second half of the year proved more challenging as sterling fell nearly 4%, applying inflationary pressure on imported goods.

Retailers are operating in an increasingly difficult environment with many consumers expected to tighten their belts over the next quarter. The household saving ratio increased sharply during 2009 with the latest figures increasing to 8.6% from 7.6% the previous quarter, the highest since 1998. Consumer confidence remained weak as the uncertainty surrounding the speed of the economic recovery remains uncertain. News that the economy only grew by 0.1% in Q4 of 2009 was clearly below expectations and is likely to dampen consumer confidence further. All these factors will put downward pressure on inflation.