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The woes of financial sector are likely to squeeze the wider UK economy even more powerfully than had been expected, while the other threat to growth – that from inflation – appears to be subsiding, according to Sir John Gieve, deputy governor of the Bank of England.

Speaking to a conference in London on Monday, Sir John’s remarks are likely to be interpreted as a sign that he is closer to supporting a cut in interest rates. He is a member of the Bank’s rate-setting Monetary Policy Committee and has so far not voted in favor of lower rates as the financial crisis deepened through the summer.

”The biggest risk to the financial sector is also the biggest downside risk to the economy; namely that damage to bank balance sheets would lead to tighter credit conditions, lower asset prices, lower consumption and investment and to a severe feedback loop into more losses for banks and so on down a spiral,” Sir John said in remarks prepared for the Family Offices Leadership Summit.

Sir John, the deputy governor in charge of financial stability, said that the Bank had been preoccupied for much of this year with the need to combat high and rising inflation, adding that in more ordinary times its single biggest concern would have been two successive letters to the chancellor to explain why inflation is so far above target.

Moreover, he said that peak inflation had not even yet arrived, and when it did, it would be around 5 per cent, compared with a medium term target of two per cent.

“But so long as the prices of wholesale energy and foodstuffs on global markets stabilize at their new higher levels, their direct impact on inflation should wash out after one year,” he said.

But the news from financial markets was very worrying, and indeed, the squeeze on banks that the MPC had been counting on to hold inflation in check could prove even more powerful than expected.

He warned that while falling house prices amounted to a redistribution of wealth rather than a loss of wealth overall – a line several Bank officials have taken in response to demands for lower interest rates – he said that housing woes would seep into the wider economy.

In addition to the need to service more expensive credit, households may increase savings rates in the expectation that they will not be able to borrow as freely.

Sir John set out a robust defense of measures the Bank has taken so far, noting that monetary policy is a crude instrument for dealing with imbalances such as mispriced risk in the credit markets.

“It is hard to believe that a somewhat tighter monetary policy would have been guaranteed to head off the credit boom and subsequent crunch altogether,” he said.

He also urged reform to bank capital and liquidity measures to put in place counter-cyclical rules. These would require banks to add more, not less, capital when their balance sheets were strong. This, in turn, could be drawn upon when losses arose, he said.