The Bank of England is likely to signal on Wednesday that Britain's economy has entered such a painful recession that there is a greater danger of too little inflation than too much.
Since the central bank's last forecasting round in August, the economy has taken a decided turn for the worse. Unemployment has shot up, house prices have tumbled and the financial crisis has escalated, forcing the government to take unprecedented action to keep major banks afloat.
The Bank shocked markets last week by slashing interest rates by 150 basis points to 3 percent, their lowest level since the 1950s. It justified the cut by saying the severity of the downturn meant there was now a clear risk inflation could fall below its 2 percent target.
Wednesday's Inflation Report will give the Bank the opportunity to explain its reasoning more fully.
If its projections show inflation below target on a two-year horizon if rates are held steady at 3 percent, it will send a strong signal that last week's rate cut will not be the last.
"I think they'll endorse market expectations of further rate cuts to come," said Amit Kara, UK economist at UBS.
"Inflation is a worry because it might undershoot, not overshoot its target."
HOW LOW WILL THEY GO?
Although low inflation is generally considered positive for economies, deflation is not because it can reinforce a recessionary spiral.
Investors have already raced to bet British interest rates will be cut to 2 percent, or even below, by the middle of next year. British interest rates have never fallen below 2 percent since Bank of England records began in 1694.
At the time of its last forecasting round in August, the central bank forecast Britain's economic growth would be broadly flat over the coming year.
That now looks way too optimistic. The economy contracted by a surprisingly sharp 0.5 percent in the third quarter and things look set to get worse before they get better. The International Monetary Fund forecast recently that Britain's economy would contract by an annual 1.3 percent in 2009.
With inflation running at a 16-year high of 5.2 percent, British interest rates are now negative in real terms. But this situation is unlikely to last. Inflation is set to crumble in the coming months as the economy contracts and commodity prices fall.
Consumer price inflation is widely expected to fall below 1.5 percent next year while retail price inflation — a broader measure which includes housing costs — could even turn negative.
"Given the extent of the interest rate cut and the Bank of England's very gloomy accompanying statement, it is clear that the central bank is now highly concerned the UK will suffer a deep, extended recession," said Howard Archer at Global Insight.
"We expect the Bank of England to slash both its GDP and inflation forecasts, thereby leaving the door wide open for a further marked reduction in interest rates over the coming months."
