Bank of England Deputy Governor Sir John Gieve yesterday dwelled upon the significant damage which could be done to UK economic activity by tight credit conditions and tumbling house prices - fuelling hopes of a cut in benchmark interest rates before the year-end.

Gieve, in a speech to the Family Office Leadership Summit in London, also expressed hopes the US government's $700bn plan to purchase toxic debt would "restore greater calm and confidence in their banking system" and "have a beneficial knock-on effect on wider international markets too".

The Bank of England's Monetary Policy Committee has held UK base rates at 5% since April, when it implemented the third quarter-point cut of this cycle.

Although benchmark UK consumer prices index inflation has surged to 4.7% in August, nearly two-and-a-half times the MPC's 2% target, Gieve told his audience yesterday: "While we must remain vigilant for any signs of inflation expectations drifting upwards, the news on that front is encouraging.

"On the other side, the risk we must be careful not to underestimate is the deflationary consequences of the credit crisis. At the moment we are focused on the risk that the slowdown in the real economy will be amplified through a contraction in banks' balance sheets."

Gieve highlighted the tightening of credit conditions for both households and businesses. This has seen an increase in the cost of loan finance, and a reduction in its availability, as banks have attempted to rebuild balance sheets amid the global crisis.

"We brought down interest rates earlier in the year to cushion the impact of the change in bank behaviour.

"In effect we have relied on the credit squeeze in large measure to produce the slowdown we consider necessary. But we are fully aware of the risk that the squeeze on banks and the feedback to the economy could prove more powerful than expected."

Gieve emphasised that any return of calmer financial markets could not be relied upon "to reverse quickly the broader macroeconomic slowdown that is underway."

He said: "Increases in retail lending rates, for those who can still get access to credit, discourage spending. Increases in credit rationing can have a more dramatic impact. If those households and companies are unable to tap other sources of finance, then their spending will have to fall in line with income.

"Spending on high-cost durable goods - such as purchases of cars and white goods by households and machines by companies - are likely to be particularly affected. And the contraction in mortgage lending pushes down house prices, further eroding the value of the collateral against which banks' loans are secured."

He added: "The process of deleveraging that was designed to alleviate pressure on banks' capital position can lead to an additional wave of credit losses, coupled with higher write-off rates, given the lower level of property prices."

Gieve also highlighted the impact of falling house prices on the broader economy. He said: "Falling house prices limit how much households and businesses can borrow and that pulls down consumption and investment."