* BoE says could cut payments on commercial bank reserves
* Governor King sees slow recovery
* King says plan needed to restore sound public finances
By Sumeet Desai and David Milliken
LONDON, Sept 15 (Reuters) - The Bank of England could cut the interest rate it pays on commercial banks' deposits, Governor Mervyn King said on Tuesday as he warned full recovery from Britain's worst recession in decades would be a long slog.
Market reaction was swift and savage. Two-year gilt yields fell to a record low and short sterling futures raced up in the busiest day for the December contract this year, especially as King also indicated an expansion to the BoE's 175 billion asset-buying programme was also possible.
"We certainly would not want to reduce the rate of remuneration on a certain level of reserves, that is part of the framework, but above some normal level we could have a lower rate at which they are remunerated," King told parliament's Treasury Committee.
"What it would do is perhaps make the banks work a little bit harder to try individually to convert some of those reserves into other assets."
Some strategists had been expecting the BoE to cut the rate it pays on reserves when it held borrowing costs at a record low of 0.5 percent last week.
But while King's comments indicate the BoE is clearly mulling the idea of improving the efficacy of its quantitative easing programme, no change is likely to be imminent.
Analysts will have to wait for more details when the BoE publishes minutes of its last Sept 9-10 rate-setting meeting next week.
SLOW RECOVERY
King was downbeat on the economic outlook, saying that despite signs of a gradual return to growth a large amount of economic slack meant inflation still risked undershooting the Bank's 2 percent target over the medium term.
"There are now signs that growth has resumed in the third quarter," King told the Treasury committee of Britain's lower house of parliament. "Looking further ahead the strength and the sustainability of the recovery is highly uncertain."
The jury was still out on whether a further expansion in quantitative easing was needed, King said.
"These are the difficult judgements we have to make -- as to whether what we've done already will come through ... providing a stimulus to broad money and spending growth in the future, or whether in fact we need to do more," he said.
He said that as far as most people and companies were concerned, the recession would not feel as if it was over for some time.
"While there is this large margin of spare capacity, that means unemployment is high and in the foreseeable future keeps rising. It will take some considerable time before that spare capacity is used up."
Earlier, official data showed British consumer price inflation slowed less than expected in August as transport costs rose, partly offsetting a downward impact from utility bills and food prices. [ID:nLF386677]
King brushed off recent criticism from former Monetary Policy Committee member David Blanchflower that the BoE had been too slow to react to the rapid worsening in the economy last year, but confirmed he had rebuked Blanchflower for describing the August 2008 Inflation Report as "wishful thinking" in a Reuters interview.
"I think it was reasonable for me to point out that this was a view that other members of the committee had been upset by ... it wasn't wise behaviour and I was asked to make that clear to him by other members of the committee." (Additional reporting by Fiona Shaikh, Christina Fincher, Kylie MacLellan and Farah Master; editing by Ron Askew)