Bank of England deputy governor Rachel Lomax yesterday signalled a willingness to cut UK interest rates further to try to counter a painful slowdown in economic growth, but only if people's expectations of future inflation remained anchored.

Lomax, whose specific remit is monetary policy, declared that a temporary spike in inflation did not necessarily mean that members of the Bank's Monetary Policy Committee needed "to tolerate a significant weakening in demand". She described the global credit market turmoil as "surely the largest-ever peacetime liquidity crisis".

Her dovish but conditional message came as a survey from the Confederation of British Industry signalled UK retailers' sales volumes in February were down marginally on the same month last year - the first such year-on-year drop since November 2006.

Lomax's speech, to the Institute of Economic Affairs' 25th Anniversary Conference, came on the day that a survey from pollster YouGov and Citigroup showed people's expectations of annual UK consumer prices index inflation in 12 months' time had fallen from 3.3% in January to 3.1% this month.

This 3.1% was the second-highest figure on record. However, the fall would seem likely to be of some comfort to MPC members as they balance the danger of a sharp slowing of the UK economy, or worse, against upside risks to medium-term inflation if expectations become dislodged.

The MPC has cut UK base rates by a quarter-point twice this cycle, on December 6 and February 7, to take them to 5.25%.

Lomax signalled scope to do more, as long as inflation expectations did not become dislodged and spill over to pay settlements and companies' price-setting and create a damaging upward spiral.

She emphasised that the risks to the MPC's central growth forecast, which anticipates a sharp slowdown in any case, lay to the downside.

And Lomax highlighted the MPC's "discretion" in choosing how long it took to return inflation to target where a major shock, such as the leap in energy prices, sent it surging.

Benchmark Brent crude was up $1.98 at a record $99.67 a barrel during trading yesterday. US light crude futures climbed as high as $101.15, only 17 cents below last week's all-time high, on a day the dollar hit a lifetime low against a basket of currencies.

Lomax said: "The MPC's remit in setting interest rates is clear - to keep inflation at 2%. But we have discretion to decide how fast to return inflation to target if it is thrown off course by a sharp shock, such as the current surge in world energy prices. So we are not required to raise interest rates sharply to counteract the rise in inflation which we expect over the next few months. We can decide what is appro- priate in the light of all the circumstances.

"Over the years, the MPC has explained that it seeks to achieve its inflation objective in the medium term by varying interest rates to steer overall demand relative to supply. If price and wage-setters do recognise that the imminent pick-up in inflation will be short-lived, then the implications of the spike for monetary policy, and for the necessary balance of demand versus supply, should be limited."

The Bank's latest central projection shows annual CPI inflation, which stood at 2.2% in January, spiking above 3% around the middle of this year.

Lomax added: "A temporary pick-up in inflation - by itself - does not mean that the committee needs to tolerate a significant weakening in demand. But if inflation expectations appear to be persistently elevated, then the committee will need to tolerate more slack to keep inflation on target. And that means it will have less scope to respond to slowing demand - the risk posed by the current turmoil in financial markets."

She highlighted the continuing crisis in advanced financial markets, triggered by a slump in the US housing market arising from default on sub-prime loans, and the renewed build-up of inflationary pressures caused by "soaring" energy and food prices as the two key developments from a UK monetary policy perspective.

Highlighting downside risks to growth, but also inflation dangers, Lomax said: "There is less than a one-in-three chance that GDP (gross domestic product) growth will be in the range containing the committee's central projection - between 2% and 3% - in two years' time. We see a greater probability - around two-in-five - that growth will be somewhere below 2%. On inflation, there's only around a one-in-four chance that inflation will lie close to the central projection, that is between 2% and 2.5%, but a more than one-in-three chance that it will be above 2.5%, and an almost one-in-five chance that it will be below 1.5%."

The UK economy grew by 3.1% last year.

Highlighting current uncertainties, Lomax asked: "Might slowdowns in other housing markets have the same potential to impair loan books and dent overall growth as in the US? What is the likely impact of further falls in global equity markets? What further scope for amplifying financial shocks lies buried in the highly-leveraged and tightly-interconnected world created by the heady pace of financial innovation over the past decade? And - going to the apocalyptic end of the spectrum - if the global macroeconomy does turn very sour, at what point might falling asset prices and mounting banking losses start to feed on each other to push economies into a deflationary downward spiral?"

In the CBI's latest distributive trades survey, 34% of UK retailers reported sales volumes in the first half of this month were up on the same period last year, with 36% saying they were lower. The rounded net 3% reporting a fall was the first negative result since November 2006, with retailers' hopes of another year-on-year rise dashed. However, retailers do not see demand falling off a cliff, and are predicting only a very marginal year-on-year fall in sales in March.

The CBI survey paints a much weaker picture than official figures last week from National Statistics, which showed a 0.8% jump in UK retail sales volumes in January. However, the CBI survey is not always viewed by economists as particularly conclusive.

And the CBI survey also highlighted inflationary dangers. Fifty-five per cent of retailers said average selling prices were up on a year earlier, with only 6% reporting a drop. The rounded net 50% reporting a year-on-year rise in prices was the strongest since August 1996 and increases are expected to continue at a similar annual rate.

A further sign of weaker economic conditions came yesterday when National Statistics reported a 0.5% fall in business investment during the final three months of last year, with the fourth-quarter total just 1.7% higher than in the final three months of 2006.