By Sumeet Desai
LONDON, Feb 9 (Reuters) - The extreme weakness of the British economy means the Bank of England could this week end up forecasting inflation at just 1 percent in two years, opening the way for further monetary easing.
The central bank's quarterly Inflation Report, due on Wednesday, will likely show the economy shrinking fast this year and inflation undershooting the BoE's 2 percent target as a result.
"Our view is that the weakness of the economy and the consequent size of the negative output gap will exert disinflationary forces outweighing the fall in sterling," said Philip Shaw, chief economist at Investec.
"We are forecasting inflation (in two years) at just below 1 percent and that is largely an output gap-driven phenomenon."
That will likely leave the door open to further rate cuts though some BoE policymakers have been arguing that there is already a lot of stimulus in the pipeline and cutting rates below 1 percent will have little extra impact.
The Monetary Policy Committee cut interest rates for the fifth month running last week -- to a record low of 1 percent.
On top of that, both sterling and commodity prices have fallen sharply and the government is throwing billions of extra pounds into the economy.
The more hawkish MPC members may prefer the Inflation Report and subsequent news conference with Governor Mervyn King give a clear signal that interest rates will stay at 1 percent for some time to come.
Finance minister Alistair Darling, probably only too aware of savers' complaints about low interest rates, said on Sunday that more BoE rate cuts would have a minimal impact on the economy.
HOW LOW CAN YOU GO?
Against that, however, is the argument that further rate cuts will still have the effect of giving companies and consumers some extra money.
The U.S. Federal Reserve had already cut interest rates to between 0 and 0.25 percent. Rates in Japan stand at 0.1 percent. The International Monetary Fund, meanwhile, has said the British economy will be the hardest hit this year among the Group of Seven industrialised nations, shrinking by 2.8 percent.
The MPC's arch-dove David Blanchflower has said British rates may never get to zero but does not exclude the possibility of rates falling to 0.25 percent.
Analysts polled by Reuters last week are divided over whether the BoE will now cut again. 32 out of the 53 polled said the central bank would cut next month.
"With rates at only 1 percent, the MPC cannot cut much further. But, we suspect that the MPC will use more of the remaining scope for loosening, bringing rates down to 0.5 percent or perhaps all the way to zero in the coming months," said Michael Saunders, economist at Citigroup.
"There is considerable scope for surprises over both the MPC's inflation forecast, as well as any other comments on the the conditions that might prompt quantitative easing."
The other open question remains as to if and when the BoE will engage in quantitative easing -- increasing the monetary base in order to boost demand.
Darling has given the BoE the powers to do this if it wishes though any such decision would require further approval from the Treasury.
"Deflationary risks are real and a large amount of spare capacity is opening as unemployment rises at its fastest pace since the early 1990s," said Charles Davis, economist at the Centre for Economic and Business Research.
"Hence, quantitative easing is the logical step. The major risks from this are the potentially negative impacts on UK gilts and sterling. This is why international coordination on such measures is vital."