By Christina Fincher

LONDON (Reuters) - Interest rates have already been cut to their lowest level since the 1950s but investors are betting they won't stop there.

With the economy reeling from the worst financial crisis in living memory and a recession a looming inevitability, inflation worries have been replaced by the hitherto unthinkable -- the threat of deflation.

In a statement accompanying Thursday's 1.5 percentage point cut to 3 percent, the Bank of England said the deteriorating economic outlook meant there was now a "substantial risk" of inflation undershooting its target.

Futures prices show investors are betting interest rates could fall to 1.75 percent next spring. That would be the lowest since Bank of England records began in 1694.

Some economists reckon rates may need to fall even further. As Japan showed after its asset bubble burst in 1990, if there is no demand for funding, even zero interest rates cannot kick-start an economy.

"The pall of gloom enveloping firms and households means that demand may be rather insensitive to interest rates at present," said Simon Hayes, an economist at Barclays Capital.

"If credit supply does not show any material recovery over the next few months the policy rate may need to be cut to 1 percent or even lower."

NEGATIVE REAL RATES