Mervyn King, Governor of the Bank of England, said today that the lack of lending by banks to consumers and businesses was the most pressing issue facing the economy and hinted that interest rates would need to be cut further.

Mr King told the cross-party Treasury Select Committee: "I am in no doubt that the single most pressing challenge to domestic economic policy is to get the banking system to get lending in any normal sense. That is more important than anything else at present."

He added that more rate cuts may be on the cards because banks were not passing the cuts on in full. “We may need to cut bank rate more than we would otherwise have done," he said. Since October, the Bank has cut interest rates by 2 per cent to 3 per cent.

Sterling tumbled after Mr King hinted of more rate cuts, falling to a session low against the dollar.

He also warned that a continuing failure of banks to lend could lead to a damaging deflationary spiral as the economy continued to shrink while inflation tumbled.

“Banks are giving up profitable lending opportunity in order to behave defensively and reduce the size of their balance sheet. Individually, that makes sense for a bank to pay them that way," he said.

"Collectively that makes no sense at all because if all banks behave in that way, then the economy will go into a steep recession and the banks will themselves see bigger losses on pre-existing loans.”

Mr King also threw his weight behind the Alistair Darling, and the Government's multi-billion pound stimulus announced in yesterday’s Pre-Budget Report.

He said the measures seemed perfectly reasonable” given the “extraordinary circumstances, but he warned that there was a “long hard road ahead” to restore stability to the economy.

While Mr King did not echo Mr Darling in pinning the blame for the country's financial woes on America, he did say that the collapse of Lehman Brothers, the US investment bank that went bust in September, was one the main drivers behind the current economic crisis.

He said: "...following the failure of Lehman Brothers, the turmoil that has affected financial markets over the past year intensified into the most serious financial crisis since the outbreak of the Great War."

The Bank has forecast that inflation will drop well below the two per cent target late next year, but some economists have predicted that inflation could fall into negative territory.

Mr King admitted that inflation could turn negative, but said that it would not necessarily lead to a damaging prolonged period of falling prices - as long as banks picked up their lending activity.

He suggested that lending levels were still falling, despite official figures showing otherwise.

“If you look at the aggregrate statistics you could be misled into thinking that the scale of total lending in the banking system is still growing at a quite comfortable rate, but much of that accounts for interim rule transactions between banks and a good deal of the rest of it is lending to the financial sector and not to the real economy," he said.

He said the Government was ready to step in. “We need effective monitoring. We don't have I think adequate monitoring of the lending that is going on," he said.

He also suggested that UK banks may have their capital adequacy rules relaxed to help ease lending conditions.

The Government is due to release a statement this afternoon about monitoring bank lending.

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