Lomax says policymakers need to balance competing risks

By Matt Falloon and Sumeet Desai

LONDON (Reuters) - Policymakers need to balance the risk of demand slowing sharply against a temporary rise in inflation becoming entrenched if people start expecting price rises, Bank of England deputy governor Rachel Lomax said on Tuesday.

"A temporary pick-up in inflation -- by itself -- does not mean that the Committee needs to tolerate a significant weakening in demand," she said in a speech.

"But if inflation expectations appear to be persistently elevated then the Committee will need to tolerate more slack to keep inflation on target. And that means it will have less scope to respond to slowing demand -- the risk posed by the current turmoil in financial markets."

Lomax also said that there had been little to change the outlook since the Bank published its February Inflation Report, suggesting she would back interest rates coming down not too aggressively.

Fellow Monetary Policy Committee member Timothy Besley also struck a similarly cautious note in an interview with the Daily Mail newspaper on Tuesday in which he said he was "largely agnostic" on whether the risk of slowing growth or rising inflation was greater.

Most economists expect the central bank to cut interest rates by another quarter point to 5.0 percent by the middle of the year.

Lomax said the continuing crisis in financial markets could act as a "significant drag" on the economy over the next two years and while the scale was uncertain, the risks were weighted to the downside.

"These are two-fold: first, that the financial crisis will persist and possibly intensify; and second that over time tighter credit conditions and asset price weakness will combine, and in the worst case feed off each other, to sap the strength of overall demand and put downward pressure on inflation."