Bank's Sentance sees increased risk of severe downturn

By Matt Falloon and Bate Felix

LONDON (Reuters) - The economy is likely to shrink in the second half of this year and the chances of a severe downturn have increased, Bank of England policymaker Andrew Sentance said Monday.

The Bank will therefore need to be alert to the risk that activity and employment may weaken much more than is needed to bring inflation back to target, he told an audience in London.

But Sentance, once regarded as one of the Bank's most hawkish policymakers, said monetary policy responses, easing inflationary pressures and government action to bolster the banking system should help the economy to recover next year.

"The combination of exceptional turbulence in the financial system and evidence of a further softening in the real economy has significantly shifted the balance of risks for the UK economic outlook," Sentance said, according to the text of his speech.

"The risk of a prolonged and severe period of falling demand and output -- resulting in much more excess capacity than is necessary to ensure inflation returns to target -- has correspondingly increased." Sentance's comments are likely to reinforce expectations that interest rates will continue to fall over the coming months as the economy weakens.

The Bank of England, in co-ordinated action by major central banks, cut interest rates to 4.5 percent from 5 percent last week as authorities around the world acted to contain the deepening financial crisis.

"A key challenge for monetary policy in the months ahead is ... to counter the increasing risk that activity and employment may weaken more than necessary to keep inflation on target over the medium term," he said.

"The MPC has received quite a bit of reassurance on medium-term inflationary pressures over the last few months. We can now be more confident than we were a few months ago that inflation will come back to the 2 percent target over the medium term."  Continued...