Interest rates will continue to come down but the Bank of England is unlikely to slash the cost of borrowing in the same way as the US, a report suggests.

The Bank's quarterly inflation report claims the Consumer Prices Index measure of inflation may jump sharply in the second quarter of the year if rates are cut drastically.

Economists have been predicting rates will be reduced to around 4.5% by the end of 2008, but the report suggests this could put pressure on inflation.

The document reveals the difficult balancing act faced by the Bank in keeping CPI in check around the Government's 2% target in the face of slowing economic growth.

It says: "The slowdown in GDP is deeper and more persistent than in the November 2007 report but the near-term pick-up in inflation is more marked, a combination that poses substantial challenges for monetary policy."

Figures this week showed CPI crept up 0.1% to 2.2% in January as rising petrol and food prices pushed up the cost of living.

But recent increases in domestic energy bills are expected to push inflation even higher in February, possibly above 2.5%, according to experts.

The Governor of the Bank of England, Mervyn King, said: "As food, energy and import prices stabilise, inflation should start to fall back towards the target.

"The challenge for the MPC (Monetary Policy Committee) is to balance two conflicting risks to the medium-term outlook.

"On the downside, a sharper slowing in activity would threaten to pull inflation below the target. On the upside, if the central projection were to materialise, then, by the end of this year, inflation will have been at or above target in all but five months in three years."

The Bank recently cut interest rates by 0.25% to 5.25% as the economic slowdown became more pronounced.

Mr King also urged banks to come clean over their losses due to the credit crunch in the upcoming reporting season.

He said: "The issue is not liquidity, the concern is counter-party credit risk and concern about the balance sheets of other banks and how big the losses will be as they are revealed in due course."

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