The Bank of England's Governor paved the way last night to unleash the weapon of “printing money” in a last-ditch drive to combat the rapidly deepening recession.

Mervyn King braced Britain for a further sharp slump and a “difficult year for all of us”, and laid the groundwork for the Bank to turn to “unconventional measures” as interest rates fall towards zero.

The Governor made clear that the Bank is preparing to turn soon to so-called “quantitative easing” measures - pumping money into the economy by buying bonds from banks, firms and the Treasury - after interest rate cuts to a record low of 1.5 per cent left it short of ammunition.

While he warned that such drastic action may be needed to limit the recession, Mr King said that the Bank was still weighing up when it should resort to it. “I stress that we are not there yet,” he said.

In a bleak assessment, the Governor conceded that the recession was tightening its grip. “A pronounced contraction in spending and output is under way,” he said. “Downward momentum intensified in the fourth quarter [of last year]. Manufacturing output is falling, and the key service sector surveys have reached record lows. Total output is the fourth quarter is expected to have fallen sharply. In the first half of this year the rate of contraction is likely to continue to be marked.”

His assessment came as unemployment figures today are expected to show that up to 100,000 people lost their jobs last month, driving the jobless total to more than two million.

Official GDP figures for the fourth quarter, on Friday, are also expected to reveal that the economy shrank by about 1.5 per cent, almost three times as fast as in the third quarter and its sharpest slump for 30 years.

Mr King said strains on the economy were being aggravated by the “difficult and prolonged adjustment” as banks unwound past, excessive lending. He said this could not be avoided in the long term, but that steps could be taken to limit the toll from it now.

The Governor spelled out how the Bank could deploy “quantitative easing”, the modern-day equivalent of printing money, to pump up commercial banks' reserves of capital, allowing them to increase lending to credit-starved consumer and companies.

He made clear that could prove vital to prevent inflation tumbling below the Bank's 2 per cent target, multiplying the danger of deflation.

Headline inflation in December registered its steepest drop in 17 years, sliding to 3.1 per cent on the consumer prices index, the lowest since last April. On the broader retail price index (RPI), steep falls in mortgage interest bills due to past base rate cuts saw inflation plunge to a seven-year low of just 0.9 per cent. RPI inflation could turn negative as soon as next month, and CPI inflation by the summer, economists said.

After the Treasury handed the Bank powers on Monday to buy “high quality” loan assets from the banks, Mr King said that he was now “actively considering” which assets it should buy to give the biggest boost to the economy. He pointed to corporate bonds and the commercial paper that allows companies to raise short-term funds as prime candidates.

If the Bank goes ahead with “quantitative easing” moves, it could also buy UK government bonds or “gilts”, which would be a step closer to pure printing of money.

But Mr King hinted that the Bank might prefer to buy corporate debt. It would “tread carefully” since any such moves would mean more risk being shouldered by taxpayers, he added.

Amid mounting gloom over the fate of the economy, the Governor attempted to offer some reassurance.

Despite an “unprecedented” world downturn, he said that the response by central banks and governments “will eventually stimulate a recovery”.

But he conceded it was hard to know when recovery would emerge. “No-one can know at what point the impact of all this stimulus will have a visible effect on activity. But well-designed policies ... will eventually work,” he insisted.

Mr King emphasised the need for international cooperation to fight a global downturn. Limiting banks' cutbacks on lending meant cross-border action was essential. “Almost every aspect of the present crisis has an international dimension.”

He blamed the crisis on a binge of lax lending by banks, and on a wall of cheap money from Asia as a result of “global imbalances”. Urgent action was needed to tackle these problems and prevent future turmoil, including new weapons for central banks and governments to prevent excessive future build-ups of debt, were needed. Governments of big economies also needed to work together to overhaul the global monetary system.

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