The sanguine tone of the Bank of England's twice-yearly Financial Stability Report has dampened expectations that the Monetary Policy Committee may cut interest rates again as soon as next week.

Howard Archer, chief UK economist at Global Insight, said today: “That the Bank appears to believe the worst of the credit crunch may be over suggests that they be more reluctant to cut interest rates.

"The more worried they are, the greater the pressure to cut rates aggressively, but that doesn’t appear to be the case. The fact that it wasn’t as downbeat as it could have been suggests they will stick with a steady but gradual cutting of interest rates”.

The MPC, which cut base rates to 5 per cent last month, meets next week and will announce its decision on Thursday.

Mr Archer believes that the next cut will come in June, but cautions that a recent batch of weak data could modestly increase the chance of a cut next week. Next week’s release of the UK service sector purchasing managers index could be critical, he suggested.

In its report, published today, the Bank of England said that the scale of losses and the economic fallout from the credit crunch may not be as bad as feared and that sub-prime write-offs could end up costing less than half market forecasts.

Current market estimates of sub-prime mortgages amount to nearly $400 billion (£201 billion) and the IMF has said that the wider cost to the financial sector could rise to $1 trillion.

The Bank said: “All of them are potentially significant overestimates of the losses within the wider economy associated with the financial market crisis,” estimating that actual losses could be closer to $170 billion.

“Using a market-to-market approach to value illiquid securities could significantly exaggerate the scale of losses that financial institutions might ultimately occur. It will exaggerate to an even greater extent the potential damage to the real economy.”

The Bank responded to pressure to ease the squeeze last week, announcing an unprecedented £50 billion swap scheme under which banks can trade in their hard-to-shift assets for risk-free government debt.

The central bank is clearly concerned about the consequences of the credit crunch, but Deputy Governor John Gieve struck an optimistic tone in a statement released with the report. “The unavoidable correction after the credit boom is proving protracted and difficult,” Mr Gieve said.

“While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.”

Nonetheless, the Bank of England cautioned that there is a risk that "the currently elevated risk premia in some markets will persist".

"This could lead to a self-fulfilling adverse cycle in which persistent market illiquidity and falling asset prices further undermine confidence in banks and results in a sharper tightening of credit conditions."

Policymakers at the Bank of England say that they are wary of rescuing institutions from the consequences of their own risky behaviour and have to balance the threat of rising inflation against the prospect of a decelerating economy, which is harder to gauge.

“Losses recorded by financial institutions erode their capital, which may reduce their ability to offer finance to other households and corporations. This may have a detrimental impact on economic performance,” the Bank said.

“But it is at least partly offset by the household sector being in a less weak state than if its mortgage debts had had to be repaid in full.”

It believes that UK banks may mark down holdings of commercial mortgage-backed securities (CMBS) by as much as £1.6 billion after the credit market slump made investors unwilling to buy the loans. British financial institutions held about £16 billion pounds of “highly rated” CMBS at the end of 2007 which may be valued in secondary markets at about 90 percent of face value, it said.

There is strong evidence to suggest the British economy is already suffering at the hands of the credit crunch, with house prices falling, home loan approvals at record lows and consumer confidence at 15 year lows.

This morning, Hammerson, the FTSE 100 property company, said that demand in the City of London office market has continued to weaken while office rents are softening.

David Blanchflower, a member of the Bank of England's Monetary Policy Committee, warned on Tuesday that policymakers must act aggressively to stave off the real risk of following America into a recession and a 30 percent slump in house prices.

Other members of the MPC have been more sanguine about the economy. Mervyn King, the Bank Governor, said on Tuesday that a period of slower growth would not be a “disaster”, and that it wasn’t all doom and gloom just yet.

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