Inflation fell sharply in December as fuel prices dropped and retailers lured customers with hefty discounts for clothes, providing cash-strapped households with some relief and the Bank of England with more leeway to ease policy further.

Policymakers are banking heavily on a steep fall in inflation to ease the squeeze on Britons' budgets, allowing them to step up spending this year and support an economy that is on the verge of recession due to the euro zone debt crisis.

Consumer price inflation fell to 4.2 percent in December from 4.8 percent in November, the Office for National Statistics said on Tuesday, showing the decline in inflation from its three-year peak of 5.2 percent in September is gathering pace.

It was the sharpest drop in the annual rate since April 2009, when the economy was deep in recession.

We expect inflation to be back at the 2 percent target by this autumn, and - while we're not convinced that it will fall back as far as the Bank of England forecasts - there should still be plenty of room to loosen monetary policy further in 2012, said Ernst & Young Item Club economist Nida Ali.

This will also provide some welcome respite for hard-pressed families who have struggled with falling real wages for much of the past five years, Ali said.

Inflation is still well above the Bank's 2 percent target, but the central bank forecasts that it will be below this by the end of 2012, as economic weakness weighs on prices and the effect of 2011's rises in sales tax and energy prices fade.

TOUGH TIMES

Clear evidence of falling inflation is a precondition for several members of the BoE's Monetary Policy Committee to back more quantitative easing, where the central bank buys assets such as government bonds to pump extra money into the economy. Most economists expect this to be announced in February.

Finance minister George Osborne said last week that falling prices gave some reason for optimism, though he acknowledged the challenging times.

Britain's economic recovery has stalled and unemployment looks set to rise further. Britain's biggest food group Premier Foods said on Tuesday it planned to slash 600 UK jobs in the face of weak consumer demand.

Unions called for higher wage settlements to put money in people's pockets. With wage settlements trailing at around two percent, people are still getting poorer in real terms, and living standards are still being squeezed, TUC General Secretary Brendan Barber said in a statement.

The ONS said clothes shops in particular started discounting before Christmas - unlike in 2010 when some raised prices in anticipation of a January 2011 rise in sales tax - in a sign of how tough the economic climate is for the retail sector.

On Tuesday, Europe's No. 2 electrical goods retailer Dixons said sales dropped 5 percent in the 12 weeks to January 7 - though it added that rivals which discounted heavily did worse.

The ONS said upward pressures from energy prices eased, taking the rate of inflation for transport to its lowest in more than a year. Fuel prices fell 0.6 percent on the month.

These trends are likely to persist. Major utilities announced price cuts of about 5 percent to their gas and electricity prices, while Britain's biggest retailer Tesco warned investors to expect flat profits as it reduces prices.

Moreover, producer prices fell for the first time in 1-1/2 years in December and business surveys point to fading cost pressures.

Nonetheless, it will take months for economists to be sure that inflation will fall back to the central bank's target, with a clear decline in underlying inflation still to materialise.

We find it difficult to argue that this outcome is consistent with inflation falling materially below target, said Nomura economist Philip Rush. Nevertheless, the MPC will probably take comfort from the decline in the headline rate and use it to support its ongoing dovish response.

(Reporting by Sven Egenter and David Milliken; Editing by Ruth Pitchford)