The pound fell sharply yesterday against both the dollar and the euro after the Bank of England signalled that it will not be deterred from cutting interest rates in the coming months by a short-lived surge in inflation above its two per cent target.
The Bank's latest quarterly Inflation Report, the first since the American sub-prime mortgage crisis triggered the global credit crunch in August, foreshadowed a worsening outlook for both economic growth and inflation.
The report's central projection showed year on year growth slipping back to little more than two per cent by next summer before starting to climb to about 2.75 per cent in 2009. That is based on the money market expectation that the Bank will cut its official interest rate to 5.25 per cent from the present 5.75 per cent.
By the same token, the Bank sees energy prices and a falling pound driving inflation up to 2.3 per cent or so in the winter of 2008/09 before settling back to the target.
"The near-term outlook is less benign for both inflation and growth," said Bank governor Mervyn King, who warned that more disruption in financial markets posed the biggest risk and stock markets around the world could still fall.
The risks to the Bank's projections are on the downside, he added - that is that the economy could suffer more - while those for inflation are evenly balanced.
Asked whether this ruled out the possibility of a recession, he pointed out that the Bank looks at year-on-year comparisons. That implies that there could still be a technical recession - two successive quarters of negative growth - without it showing on the Bank's charts.
First reactions to the prospects of lower British interest rates came on the currency markets where sterling fell by more than a cent against the euro to finish at a four-year low of 71.27 euro cents, while against the dollar it came back by 1.11 cents to $2.059.
Earlier Mr King pointed out that the pound had already fallen by four per cent against the euro since August and by three per cent against a trade-weighted "basket" of currencies.
He insisted that the Northern Rock crisis and the wider credit crunch will have no long-term impact on Britain's financial system. "When we get through it, people will realise that the underlying economy is sound," he said.
"If you are looking at a currency unit with a stable effective exchange rate you couldn't do better than the pound."
It had been stable over the past ten years.
Alan Clarke, an economist at BNP Paribas, commented: "Crucially, the Bank has validated expectations that we are going to see two or three interest rate cuts in 2008."
Mr King warned that the present financial turmoil probably has several more months to run. But British banks should be able to withstand losses arising from investments in the US sub-prime mortgages.
"I would urge everyone to see the losses in the context of past profits and the capital cushion of the banks. The big five banks have made over the past five years about £100 billion of profits," he said.
That would provide a cushion for the banking system now.
