Bank's Gieve eyes deflationary impact of credit crisis

By Christina Fincher

LONDON (Reuters) - The Bank of England needs to remain vigilant for any rise in inflation expectations but must not underestimate the deflationary impact of the credit crisis, Bank Deputy Governor John Gieve said on Monday.

In a speech in London, Gieve stuck a dovish tone, saying he was encouraged by signs that commodity prices may have peaked and that wage inflation remained muted.

He noted sterling's fall on the foreign exchanges would partly offset the impact of falling commodity prices but said there was a risk the credit crisis could exert such a strong downward tug on the economy that inflation fell below target in the medium term.

"While we must remain vigilant for any signs of inflation expectations drifting upwards, the news on that front is encouraging," he said. "On the other side, the risk we must be careful not to underestimate is the deflationary consequences of the credit crisis."

Gieve, who is in charge of financial stability at the central bank, said he hoped the rescue package recently announced by U.S. authorities would restore greater calm to the markets but warned policymakers would not lower their guard.

"We will continue to monitor the situation closely, in consultation with our counterparts in the U.S. and elsewhere, in order to judge whether any further measures are needed," he said.

DOWNSIDE ECONOMY RISKS

Gieve said the credit crunch had affected all parts of the bank's policymaking, from the setting of interest rates to its work with the Treasury and Financial Services Authority on financial regulation and the scale of its money market operations.