Bank signals more rate cuts as economy shrinks

By Sumeet Desai and Christina Fincher

LONDON (Reuters) - The economy will shrink sharply next year and inflation will tumble, the Bank of England predicted on Wednesday, suggesting that it will cut interest rates even below their current half-century low.

In its gloomiest set of forecasts in more than a decade, the central bank said the economy had probably already entered recession and was likely to contract more throughout 2009.

Annual inflation, which is at 5.2 percent, would fall to just below 1 percent in two years, half the central bank's target, it forecast a week after making a shock 1.5 percentage point interest rate cut to 3.0 percent.

The pound tumbled to a record low against the euro and to a 6-year trough against the dollar as investors priced in more rate cuts.

"We are certainly prepared to cut Bank Rate again, if that proves to be necessary. There are many things to learn between now and our next meeting," Bank Governor Mervyn King told a news conference after the forecasts were published.

King refused to speculate how low interest rates would eventually need to go. But analysts are now predicting that borrowing costs could fall another percentage point to 2.0 percent and perhaps go even lower for the first time ever.

"The Bank of England's Inflation Report leaves us with the clear impression that the 150 basis point cut in the Bank Rate is not the end of the monetary policy stimulus," said James Knightley, economist at ING. "We had been expecting rates to fall to 2 percent by January, but we now favour rates falling further to 1 percent."

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