Mervyn King, Governor of the Bank of England, today signalled that inflation could fall as low as 1 per cent next year, despite a smaller-than-expected decline in the cost of living to 4.1 per cent during November.

In a third letter to Alistair Darling, the Chancellor, explaining why Consumer Price Index (CPI) inflation remains more than 1 per cent above the Government's 2 per cent target, Mr King also said more help was needed to accelerate lending to individuals and households.

Inflation declined from 4.5 per cent in October to 4.1 per cent in November, which is the lowest level since June but is higher than the 3.9 per cent forecast by economists.

While inflation was helped by the falling price of oil, the cost of fruit kept the cost of living higher than expected after doubling to 10.8 per cent, with a particular increase in the price of oranges, bananas, pears and strawberries.

However, the recent cut in VAT from 17.5 per cent to 15 per cent, announced in last month's Pre-Budget Report, is expected to reduce inflation by 1.3 per cent in December.

The Bank of England Governor must write to Chancellor if the CPI rate of inflation falls 1 per cent or more above or below the Government's 2 per cent target.

Mr King said today: "It is possible that I will not need to write a further open letter to you in three months' time.

“Indeed, given the short-term outlook for inflation, it is quite possible that I will next need to write to you to explain why inflation has deviated by more than one percentage point below the target in 2009.”

A steep fall means that the British economy could be heading for a period of deflation, which will continue the damage being wrought on British businesses as consumers stop spending.

Mr King also hinted today that more measures could be introduced to encourage lending in the UK.

He said: “Additional measures, building on the Government’s package to support the banking system announced in October, will probably be required to underpin lending to households and companies.”

Although Mr King expects inflation to fall substantially, the Bank is still expected to make more rate cuts to protect the UK economy against the coming recession.

UK GDP shrank in the third quarter and is expected to fall again in the current quarter - the technical definition of a recession is two consecutive quarters of negative growth.

Howard Archer, chief UK and European economist at IHS Global, said: "We expect the Bank of England to reduce interest rates by at least a further 75 basis points from 2.00 per cent to 1.25 per cent in January."

"We believe that the Bank of England would like to moderate the pace at which it is cutting interest rates as they near zero, but another 100 basis point reduction is certainly possible in January if the data indicate that the downturn is continuing to deepen."

Mr Archer added the Bank could cut as low as 0.5 per cent - the same rate the US Federal Reserve is expected to reduce its borrowing costs to when it makes its announcement later today.

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