Deflation tightened its grip on the economy last month after a record fall in retail prices.

The retail prices index (RPI), the benchmark for pay deals, fell to -1.2 per cent, the lowest since records began in 1948, dragged down by a decline in energy and mortgage costs.

Economists expect that prices may fall farther as the recession takes its toll and unemployment rises. Some believe that the rate could fall to about -2.7 per cent, raising fears of prolonged deflation as consumers delay purchases and businesses withhold investment.

Inflation on the consumer prices index (CPI), the Bank of England’s target measure, which does not include housing costs, fell to its lowest level in a year, dropping from 2.9 per cent to 2.3 per cent in April.

While this is closer to the Bank’s 2 per cent target, consumer prices are expected to continue to tumble with some economists forecasting that they will fall into negative territory too.

There was good news for shoppers as yesterday’s figures from the Office for National Statistics showed that many food prices fell during the month. But the drop in RPI inflation was a blow for pensioners relying on income from index-linked annuities. Many will see no increase in their annual payment, while some customers of Prudential and Standard Life will actually see payments cut. Those on state pension are more fortunate. The Government has pledged that these will rise by at least 2.5 per cent.

Business groups have warned that private sector employees could also be hit hard. About one in ten pay deals is linked to RPI and experts have said that tumbling inflation coupled with the recession will leave businesses with difficult decisions on pay.

Lai Wah Co, head of economic analysis at the CBI, said: “With inflation at such a low level, and with companies being squeezed by the recession, pay rises are likely to be very modest this year. In many companies there will be no pay rises at all. It is important for people to understand the environment in which firms are having to make wage decisions.”

Public sector employers are offering pay rises of between 0.3 per cent and 1 per cent in an effort to keep costs down. But they are hampered by existing three-year deals for many groups including nurses, teachers and senior civil servants.

The union Unison argues that public sector workers have been hardest hit by the recession and were not fully compensated for the high levels of inflation last autumn, which pushed food, fuel and housing costs up. However, unions realise that they may not gain public sympathy for strike action this year when settlements in the private sector are much lower.

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