2nd UPDATE: BOE King: Fiscal Stimulus Will Mitigate Slowdown

LONDON --Bank of England Governor Mervyn King said Tuesday that economic stimulus measures announced by the U.K. government Monday will reduce slowing in activity over the coming year, while a cut in value-added tax will slow inflation in the short run.

In an opening statement to U.K. policymakers, King said the inflation rate was falling sharply and was likely to return to target in early 2009. However, the rapidity of its fall will depend on the speed of the decline in sterling.

"Yesterday, the chancellor announced measures designed to support aggregate spending in the short run," King said.

"These measures will act to mitigate the slowdown in activity over the next year," he said.

Chancellor of the Exchequer Alistair Darling Monday announced a stimulus package totaling GBP20 billion that is designed to limit the depth and duration of the recession.

Between the fiscal year ending March 2009, and the fiscal year ending March 2013, the government now plans to borrow GBP458 billion, an increase of GBP295 billion on the plans it announced in March. That will take public sector debt to GBP1.1 trillion, or 57.4% of gross domestic product.

It is likely to be "well into next year" before the impact of economic stimulus becomes evident, King said, adding that the degree of fiscal stimulus was suitable.

"In these extraordinary circumstances, modest fiscal stimulus was perfectly reasonable and appropriate" if it was temporary and there was a clear path back to fiscal sustainability, King said. "I think the announcements yesterday meet those two conditions, but the proof of the pudding will be in the eating."

Nevertheless, the path back to fiscal sustainability will be "long and hard," King said.

That view was backed up by Deputy Governor for Financial Stability John Gieve who said that while the level of borrowing was "extremely high," it was warranted.

"It is certainly achievable," Gieve said, when asked whether the path set out by the government was credible. "It's perfectly possible to do, but it does require sustained determination," he said.

Deputy Governor for Monetary Policy Charlie Bean said the cut in VAT was a "sensible" measure.

While the decline in inflation will be swift, the BOE's core forecast is still that consumer price inflation will remain in positive territory, although a brief descent into deflation can't be ruled out, King said.

On the risk of a deflationary spiral, King said: "I don't think we feel that is the position we are in or are likely to be in."

The most pressing task for the U.K. authorities is to ensure that normal bank lending is resumed, King said. "Without that, the downturn in activity could become protracted and extremely damaging," he said.

"One way or another we have to find a means to get the bank system lending," King said. If it takes a "concordat" to achieve that "so be it," he added.

He quipped that the London interbank offered rate was "the rate at which banks do not lend to each other."

Rate cuts by the central bank should compensate for a rise in bank margins, he said.

King said that the raising of capital by banks was vital, not only to protect the institutions themselves, but to ensure the flow of lending at reasonable rates.

If it turns out that banks do need more capital, the U.K. authorities shouldn't "shy away" from that, he said. "In the last resort, you can't rule out measures where the government has to intervene directly" to ensure lending flows, King said.

He also said that he wouldn't exclude the need to nationalize more banks, adding that in times of financial crisis it would be a serious error to rule out anything.

King said a failure in the buildup to the crisis was not preventing the very rapid expansion in the size of the financial sector, and there was "a genuine policy objective" to not let the banking system become too big.

"The lesson to be drawn, is not that the Bank should be diverted from its task (of targeting inflation with interest rates) but that we need new policy instruments that can be used to stabilize the growth of the banking sector," King said, referring to macroprudential measures.

He also said there would be an announcement by the U.K. Tripartite authorities - the BOE, the Treasury and the Financial Services Authority - later Tuesday on measures to monitor bank lending.

King said that the chancellor would need to reflect on how a plan to auction guarantees for mortgage backed securities, announced Monday, would fit in with existing credit guarantees, saying it doesn't make sense to have two separate packages.

He said he was "all in favor" of finding a means to ensure sustainable mortgage lending, "but I'm not entirely confident the best way to do this is to resurrect an instrument that has quite rightly fallen out of favor."

King also stressed that the Monetary Policy Committee had not "at any point" come under government pressure to reduce interest rates.

-By Natasha Brereton, Dow Jones Newswires; +44 20 7842 9254; natasha.brereton@dowjones.com

(Laurence Norman contributed to this report.)