The Bank of England today backed the Government's £20 billion gamble to save the economy but hinted that further cuts in interest rates are still needed.

Governor Mervyn King said the "modest" measures outlined in the Pre-Budget Report are "perfectly reasonable" given the threat of a deep recession. He told MPs on the Treasury Select Committee: "These measures will act to mitigate the slowdown in activity over the next year."

However, he warned there will be "a long hard path" ahead to restore stability to the economy and get the public finances back in order after the Chancellor's unprecedented borrowing binge.

"I thought in these extraordinary circumstances a modest fiscal stimulus was perfectly reasonable and appropriate, provided it met two conditions," said King. "The first condition was that it was temporary, and the second condition was that it set out a very clear path back to fiscal sustainability.

"I think the announcements met those two conditions, but of course the proof of the pudding, in terms of ensuring that we go back to fiscal sustainability, will be in the eating. And there is a long hard path back to sustainability."

King also hinted at a further interest-rate reduction next week following this month's dramatic cut from 4.5% to 3%. He said the refusal of many banks to pass on the cut to borrowers meant the Bank's monetary policy committee may have to act again.

"The committee understands that this means we may need to cut Bank Rate more than we would otherwise have done," he said. "I am in no doubt that the single most pressing challenge to economic policy is to get the banking system to resume lending in any normal sense. That is more important than anything else at present."

King said the cut in VAT from 17.5% to 15% meant it was now "very likely" the UK will suffer a short bout of deflation. Inflation is currently at 4.5% but looks set to crash back below the 2% target in coming months as retailers pass on VAT cuts and oil and food prices tumble.

"Over the next few months inflation will be markedly lower than we anticipated in August," said King. "The MPC will take whatever action is necessary to ensure that inflation is close to target in the medium term and, in doing so, to help the economy resume growth at a sustainable rate."

The City was today betting on another aggressive cut in interest rates next week by a minimum of 0.5 of a percentage point to 2.5%.

"These are generally pretty dovish comments that reinforce belief the Bank of England will deliver another hefty interest-rate cut," said Howard Archer at Global Insight.

George Buckley of Deutsche Bank said: "While the PBR should provide a helpful boost to the economy at a time when it is desperately needed, there is no guarantee that this will be enough. We continue to expect the Bank to cut rates next week."