MARK WILLIAMSON mark.williamson@theherald.co.uk THE deputy governor of the Bank of England said yesterday that he could not rule out a recession and that the risk of one had increased as the credit crunch dragged on in the past two months.

However, with monetary policymakers expecting inflation to top 4% later this year, Sir John Gieve provided a fresh indication that the Bank would not hurry to cut interest rates to help avoid a slowdown.

Speaking at the London Stock Exchange, Gieve said he was concerned that the turmoil in credit markets sparked by the sub-prime crisis in the US last year had lasted longer than expected.

"Am I satisfied with the state of tensions in financial markets? No, not at all. It's going on longer and it's more fragile and fraught than I would like," said Gieve, who noted three cuts in interest rates since December had not persuaded lenders to make credit easier to obtain.

With recent data suggesting that "the economy is already slowing fast", Gieve warned that the UK faced an uncomfortable year. "Inflation will continue to rise sharply while growth tails off and unemployment picks up.

"I can't rule recession out," said Gieve, who in January warned that fallout from global financial market turmoil posed a "serious downside risk to growth" in the UK.

But, coming days after the Office for National Statistics said that annual inflation surged to 3.8% in June from 3.3% in May, the speech indicated that Gieve regarded the prospect of sustained increases in inflation as an equally grave threat.

Gieve said the Bank was "expecting inflation to be well over 4% for much of the rest of the year" compared with a target of 2%.

"With inflation rising well above target we need a period of slower growth to create a margin of spare capacity.

"I can assure you that we will do whatever it takes to bring inflation back to target in the medium term."

After voting unsuccessfully for a cut in interest rates in March (from 5.25%), Gieve may be back in the hawks' camp.

Gieve was one of five of the nine Monetary Policy Committee members who told MPs they considered increasing rates at the June meeting. Borrowing costs were held at 5%.

"If the sharp credit squeeze was the only challenge we faced, the MPC would be expected to continue reducing rates to mitigate the risks of an excessive fall in demand. But we do face another simultaneous shock, the sharp rise in commodity prices, which is driving up inflation across the world. That raises the question of whether we should be raising rates."

Gieve said the rising cost of regularly purchased essentials, like food and petrol, was probably responsible for the upward drift in people's inflation expectation.

This increase largely reflected rising world commodity prices, which could not be avoided.

"But we must ensure that inflation returns to target when this year's increases fall out of the index in a year's time. That means ensuring that the higher rate of inflation does not become embedded in the expectations of wage and price setters."

Last month Bank Governor Mervyn King warned that people would have to bear a squeeze on real take-home pay this year, and lambasted those who claimed the MPC should focus on growth rather than inflation.

Separately, European Central Bank president Jean-Claude Trichet affirmed that the ECB expected inflation would ease to its target level of around 2% in about 18 months, from 4% in June, and the eurozone economy to return to moderate growth later this year.

The ECB recently raised its benchmark interest rate to 4.25% from 4%.