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The City was last night bracing itself for interest rates to be cut to a record low of 1% next year, as the Bank of England seeks to prevent a deepening recession from pushing the UK economy into deflation.
Sterling fell sharply yesterday after Mervyn King, the Bank's governor, said that in "exceptional and difficult times" the nine members of the monetary policy committee would do "what was needed" to prevent a period of falling prices.
Financial markets believe that the prospect of sharply lower growth and weakening inflation may prompt the MPC to follow last week's 1.5 percentage point cut with a further 1 point reduction in December, and that the bank rate may drop to 1% early in the new year.
Official interest rates have not been lower than 2% since the Bank was founded in 1694, but King signalled yesterday that a fresh easing of policy will be needed to keep inflation as high as the government's 2% target during 2009.
The governor said that "the economic landscape had changed" since the Bank's last in-depth analysis three months ago. Speaking shortly after official data showed a hefty rise in unemployment in October, King said that growing evidence of recession, mayhem in the financial markets and the more than halving of oil prices had prompted the Bank into taking decisive action on borrowing costs.
King said that it was "very likely that the UK economy entered a recession in the second half of this year".
The governor backed tax cuts from the government in the pre-budget report - which the Treasury announced yesterday would be on November 24 - provided they were short-term and part of a medium-term plan for controlling the budget deficit.
"We have been expecting rates to fall to 2% by January, but we now favour rates falling further to 1%," said James Knightley of ING Financial Markets. "It is not impossible that the UK's bank rate falls to 0.5%, matching our forecast for the Fed."
Nick Parsons, head of strategy for NAB Capital, said the Bank could not afford to disappoint the City, which was braced for a 1 percentage point drop in rates in December, taking the bank rate to 2%.
Official data showed that the broadest measure of unemployment, the Labour Force Survey, rose 140,000 in the July to September period from the previous three months, to 1.825 million, its highest level since the end of 1997. And the narrower measure of joblessness, the claimant count, showed a 36,500 jump to 980,900 in October, the biggest rise since the depths of the early 1990s recession.
The figures also revealed a plunge in job vacancies to a five-year low, while the number of redundancy announcements shot to a three-year high. Both figures mean unemployment rose sharply.
In the last two recessions, of the early 1980s and early 1990s, both measures of joblessness peaked at around the three million mark, and many labour market experts expect that to happen again.
The Liberal Democrat Treasury spokesman, Vince Cable, said: "It's clear from today's figures that we're heading for very high levels of unemployment with falling inflation. This could soon become negative inflation, with prices actually falling."
The Bank's gloomy outlook for the economy, combined with another big rise in unemployment, pushed the pound below the $1.50 level to its lowest against the dollar for six and a half years.
Sterling also tumbled to a fresh record low against the euro of 83.84, spelling more expensive holidays for Britons travelling to Europe.
Oil prices, though, set a fresh 20-month low of just below $57 a barrel for US crude futures, and $53.3 for Brent. The AA reported a further fall in petrol prices, to an average of 95.6p a litre for unleaded fuel.
The FTSE 100 share index also fell heavily, shedding 1.5% to close at 4,182 not far above the lows around 3,900 seen last month.
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