The weakening in the British economy argues for further interest rate cuts but policymakers need to balance that against rising inflationary pressures, Bank of England Deputy Governor John Gieve said on Thursday.
In a speech to businesses in the north east of England a day after he announced he would quit his post early next year, Gieve said the Monetary Policy Committee was facing the most challenging conditions since it was set up in 1997.
"Balancing the downside risks to demand associated with tighter credit conditions against the inflationary pressures emanating from the rest of the world is an enormous challenge," he said, according to the text of his speech.
"And the immediate prospect is for a deterioration in both output growth and inflation."
Inflation hit a series-high of 3.3 percent in May, figures released on Tuesday showed, and markets are pricing in hikes in borrowing costs later this year. Economists, however, are unsure and many still believe economic weakness will force rate cuts.
Gieve said there was no doubt the credit crunch is having a "material effect" on the economy, most obviously in the housing market where prices had already fallen around 7 percent from their peak and were expected to fall further.
"If nothing else were going on, the MPC would expect this prospective weakness in overall demand to put downward pressure on inflation in the medium term and that would be pointing to further rate cuts," he said.
"However, there is something else going on," he added, namely soaring global commodity prices, pushing up inflation.
But Gieve said the MPC was conscious that setting interest rates to get inflation back to target too quickly could result in "unnecessary volatility in output and employment."
"Instead we are focused on returning CPI inflation to the 2 percent target in around 2 two years, when the present sharp rises in energy and food prices will have dropped out of the CPI inflation rate," the deputy governor said.
"We judge that in order for inflation to slow this year, reducing the pressure on the supply capacity of the economy and dampening increases in prices and wages."
