LONDON (Reuters) — British inflation slowed much more than expected in January as fuel costs fell, raising hopes the Bank of England's battle with rising prices is over.But economists say the BoE's new forecasts today will give a better indication of where interest rates are heading, given worries over wages and consumer demand.

The Office for National Statistics said yesterday that consumer prices fell 0.8 percent last month, taking the annual rise to 2.7 percent from 3.0 percent in December.

Not a single analyst polled by Reuters had predicted the steep drop in the annual rate, the biggest in four years, and the pound fell half a US cent and the FTSE 100 index of leading British shares rose after the figures.

Financial markets had been pricing in the risk of two more rate hikes this year before the data, but investors now only see one rise following last month's surprise hike to 5.25 percent.

"Our guess is inflation will continue to fall sharply over the course of the year," said Investec economist Philip Shaw.

"That means the risks that (BoE Governor) Mervyn King has to write a letter to the Chancellor are further reduced and may even mean that a further interest rate rise is staved off."

Inflation has been above its 2 percent target since May 2006 and King last month narrowly escaped having to explain to Chancellor of the Exchequer Gordon Brown why it had deviated far from that target.

If CPI moves more than 1 percentage point from target, an explanatory letter to the government is required.

The softer than expected inflation reading may even lead some to question the need for the BoE's surprise rate hike last month given price pressures already seem to be easing.

Furthermore, there are growing signs the housing market is starting to cool after Europe's second-largest listed property manager British Land cautioned higher interest rates would help tame price growth.

Attention will now turn to the BoE's quarterly Inflation Report today, which will shed light on policymakers' views on medium-term price pressures — information far more likely to sway the rate outlook than one month's CPI data.