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Bank of England Governor Mervyn King said Britain’s inflation rate may fall next year to the lowest since 2002, indicating policy makers will keep cutting borrowing costs.

King, writing to Chancellor of the Exchequer Alistair Darling to explain why inflation exceeds the government’s 3 percent upper limit, said the rate may fall below 1 percent next year as the economy worsened more than the central bank forecast last month. The bank’s target is to keep inflation at 2 percent.

“It is likely that overall CPI inflation will return to target in the first half of 2009 and then move materially below it later in the year,” King said. “It is quite possible that I will next need to write to you to explain why inflation has deviated by more than one percentage point below the target.”

The U.K. economy shrank in the third quarter as banks rationed credit and house prices plunged. Inflation, pushed up by higher energy costs last year, is retreating as oil prices tumble and shops bring forward sales to lure consumers concerned they may lose their jobs.

“The U.K. recession is likely to be so severe that inflation will fall sharply,” Michael Saunders, chief European economist at Citigroup Inc. in London, wrote in a note to clients.

Rates Falling

The Bank of England is cutting borrowing costs along with the U.S. Federal Reserve, which economists say will lower the rate to 0.5 percent from 1 percent at its decision today. European Central Bank President Jean-Claude Trichet, by contrast, signaled that further interest-rate reductions may be limited after a cut to 2.5 percent on Dec. 4.

The U.K. inflation rate fell to 4.1 percent in November from 4.5 percent the previous month, the statistics office said today. The rate peaked at 5.2 percent in September after oil prices surged to a record $147 a barrel earlier this year.

The pound fell to a record low against the euro yesterday as investors bet on more rate cuts. The pound has dropped more than 20 percent against the euro this year and traded at 89.68 pence after the report. Earlier, it declined to 89.78 pence.

The U.K. central bank this month lowered the benchmark interest rate to 2 percent, the lowest since 1951. The main lending rate has dropped 3 percentage points since October. The rate will drop to 1.5 percent at the next decision on Jan. 8, the median of 23 economists’ predictions in a Bloomberg News survey shows emergency payday loan.

Third Letter

U.K. law requires the central bank to governor to write an open letter to the government when inflation misses the 2 percent target by more than a point. Today’s letter is his third this year and the fourth since the bank was given the power to set interest rates independently in 1997.

Prime Minister Gordon Brown’s government last month cut sales tax to 15 percent from 17.5 percent as part of a stimulus package for the economy. King said that will further depress prices, while the depreciation of the pound will offset some of those drops.

Since the bank last updated its projections for growth and inflation in November, “the immediate outlook for activity has deteriorated further,” King said today. After the economy shrank 0.5 percent in the third quarter, “business surveys and other information point to a sharper contraction in output in the fourth quarter.”

Treasury Reply

Darling replied to King’s letter by saying that the Treasury “remains committed to the objective of allowing fiscal policy to support monetary policy and will continue to support the MPC in the forward-looking decisions it takes.”

Oil costs have dropped by more than 60 percent since July’s record, and stores are lowering prices to attract shoppers. Transport costs were the biggest contributor to the drop in the inflation rate last month, the statistics office said today.

The inflation rate peaked at 5.2 percent in September and has exceeded the 2 percent target for 14 months.

Woolworths Group Plc, the highest-profile victim of the consumer spending slump, started a closing-down sale last week offering 50 percent reductions on goods from DVDs to clothes and candy. The chain, which opened its first store in 1909, went into administration this month, affecting more than 25,000 jobs.

Consumers’ expectations for inflation slipped to the lowest since at least 2005 this month, Citigroup Inc. said yesterday.

While inflation should hit the Bank of England’s 2 percent target in the first quarter, “getting it to stay there will be like catching a knife,” said Matthew Sharratt, an economist at Bank of America Corp. in London. “Policy right now is all about preventing prices from going through the floor.”

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