LONDON - Retail sales unexpectedly fell in December, despite heavy discounting, with a slowdown on the high street striking at the busiest period for retailers and opening the door for an interest rate cut next month.

The pound fell and interest rate futures rose as investors bet Bank of England policymakers will not hesitate to lower borrowing costs in February as the economy slows in the wake of the global credit crunch and consumers feel the pinch.

The Office for National Statistics said sales fell 0.4 percent last month, its weakest monthly showing since January 2007 and confounding forecasts for a 0.2 percent rise.

That took the annual rate down to 2.7 percent from a downwardly revised 4.2 percent in November, its lowest since September 2006.

The data came in worse than economists had predicted but trading updates from retail bellwethers Tesco and Marks and Spencer in the past two weeks indicated Christmas spending was hit by rising energy prices and weakening house markets.

"We don't think things are getting any better from here," said Vicky Redwood, an economist at Capital Economics. "House prices are falling, so are equity prices, utility prices are rising, confidence is at a 12-year low... Need we go on?"

"Surely this is enough to cement a February rate cut and more cuts thereafter."

The Bank cut borrowing costs by a quarter point to 5.5 percent last month and markets expect rates to fall another two to three times this year as signs of a slowing economy emerge across the board.

The ONS said the retail sector had now entered a slowdown in growth, with December's decline driven by the worst performance by general mixed retailers, which include department stores, for more than 13 years.

The three-month trend rate of retail sales slowed to 0.4 percent in December from 1.0 percent in November, its weakest since March last year.

CONSUMER BOOM FADES

The weaker than expected readings came despite increased discounting by retailers, with the implied deflator measure of prices down 1.2 percent on the year, the weakest since September, indicating little inflation pressure on the high street.

"The consumer boom is starting to pop and unless the Bank of England are very careful they could deflate it into a much deeper downturn," said David Brown, chief European economist at Bear Stearns International.

"The Bank of England needs to get rates down quickly and cut rates again in February ... Inflation is not the danger but the risk of deeper downturn is."

Retailers have reported mixed fortunes over the crucial Christmas period with Marks and Spencer suffering its worst festive season in more than two years, but department store John Lewis faring better.

Tesco, Britain's biggest retailer, showed on Tuesday it was not immune to consumer caution at Christmas, reporting a slowdown in core sales at home while international growth surged.

"The Bank of England does need to move quickly," Tesco's Finance and Strategy Director Andrew Higginson said.