By David Milliken and Fiona Shaikh
LONDON (Reuters) - The escalating danger from the neighboring euro zone debt crisis prompted the Bank of England on Wednesday to keep alive the prospect of more help for an ailing British economy it said was growing more slowly than expected.
At a news conference after unveiling the bank's latest economic forecasts, Governor Mervyn King also took aim at the euro zone, which is struggling to contain a renewed risk of Greece falling out of the currency bloc.
"The euro area is tearing itself apart without any obvious solution," he said.
The central bank took a gloomier view of Britain's growth than before and, in a surprise to markets, lowered its medium-term inflation prediction - a sign that while more stimulus for the economy is not immediately on the cards it could come if conditions worsen.
However, a big upward revision to its short-term forecasts means inflation will take nearly a year longer than previously expected to fall back to its 2 percent target, posing a hurdle for any immediate stimulus.
Britain has not fully recovered from the 2008-2009 slump that left many Britons poorer. But the central bank still opted to halt the money printing press last week although the economy slipped back into recession earlier this year.
"We don't know when the storm clouds will move away. But there are good reasons to believe that growth will recover and inflation will fall back," King said.
He warned of a long and treacherous road ahead.
"We have been through a big global financial crisis, the biggest downturn in world output since the 1930s, the biggest banking crisis in this country's history, the biggest fiscal deficit in our peacetime history and our biggest trading partner (is) the euro area," he said.
"The idea that we could reasonably hope to sail serenely through this with growth close to the long-run average and inflation at 2 percent strikes me as wholly unrealistic. We're bound to be buffeted by this," he said.
The failure in Greece to form a government has stoked fears of a disorderly Greek exit from the common currency that could trigger meltdown of the global banking system.
Britain has been urging its banks to make contingency plans for at least six months, and King said that irrespective of whether there was a euro zone break-up, the way ahead would be painful for Britain as well as the rest of the EU.
AUSTERITY
The lack of growth has led to criticism of the BoE and Britain's Conservative-led government, which is finding it harder to defend its five-year program to eliminate a huge budget deficit with tax hikes and spending cuts.
A new poll showed that the Conservatives carefully crafted image of economic competence is ebbing away, and Cameron said that the euro zone had to decide to "make up ... or break up".
Most economists think that the BoE will be reluctant to engage in another round of asset purchases with newly created money, known as quantitative easing, after buying a total of 325 billion pounds ($523 billion) in gilts, as inflation has proven stickier than forecast so far .
But King said more stimulus remained an option, and analysts took the unexpectedly low two-year inflation forecast as a sign that the policymakers had room to do more if needed.
"The possibility of more QE is very much on the table," said RBC gilts strategist Sam Hill. "I don't think we should be surprised if marginal deteriorations in the euro crisis means that the Bank delivers more stimulus over the course of the next couple of months."
Sterling fell to a fresh four-week low against the dollar and a session low against the euro, while 10-year gilt yields hit a record low below 1.83 percent as traders bet on further BoE gilt purchases.
Britain's economy shrank again in the first quarter and the central bank indicated that an extra day off for the Queen's Diamond Jubilee would hit growth in the second quarter.
Business surveys have painted a more positive picture of the economy and, in another sign of some underlying resilience, the number of Britons out of work fell at the fastest pace in nearly a year in the three months to March.
As in previous Inflation Reports since the crisis, the central bank had to revise up its near-term inflation forecast and cut its growth outlook.
However, the upward revision to inflation over the next year was much more marked than in the last report, with the BoE blaming rises in energy prices and indirect taxation, as well as weaker-than-expected productivity growth.
Inflation was now likely to remain above the 2 percent target for the next year or so, it said. In two years' time, inflation is forecast to be around 1.6 percent, compared to 1.8 percent in the BoE's February forecast.
Weak productivity - possibly due to a dysfunctional banking system that is blocking new investment - means that Britain's economy may struggle to grow strongly without generating excess inflation for the next 2-3 years, King said.
At this point, annual growth will have recovered to around 2.7 percent, about 0.3 percentage points lower than previously forecast. But it could take as long as 20 years for total economic output to get back to where it would have been without the financial crisis, King said.
"There is no obvious reason to believe that we can't get back to the level of output that we were on the pre-crisis trend path (but) it doesn't follow ... that you can just put your foot on the accelerator ...to expand output."
(Additional reporting by Guy Faulconbridge, Peter Griffiths, Michelle Martin, Olesya Dmitracova and Yeganeh Torbati; writing by Sven Egenter. Editing by Jeremy Gaunt.)
