The Monetary Policy Committee (MPC) of the Bank of England meets today, a month after it surprised markets with an interest rate cut of 1.5 points. Since then, evidence of a sharp slowdown in growth has only accumulated. Manufacturing output is contracting at an annual rate of 10 per cent. The housing market continues to weaken. New mortgage approvals are around 75 per cent below their peak, and falling.

A further cut in interest rates is urgent. A one-point cut today, to 2 per cent, would give the right signal to consumers, businesses and investors. There are plausible arguments for cutting rates further. But owing partly to earlier policy mistakes, there are constraints on how far monetary policy can be eased, at least in one go.

The immediate reason that interest rates ought to be cut significantly is the outlook for inflation. The MPC's remit is to target consumer price inflation. The latest release showed the annual rate of inflation well above the target of 2 per cent but rapidly decelerating. The decline to 4.5 per cent from 5.2 per cent the previous month was the largest monthly fall since the consumer price index was introduced in 1997. External developments are compounding the effect of the domestic slowdown. Most significant is the collapse in oil prices, from $147 a barrel in July to less than $50 now. There is a serious risk that inflation will undershoot the Bank's target next year even to the point of turning negative.

Prolonged falling prices (deflation) might sound like a good thing for consumers. It would in reality be an economic catastrophe. An already heavily indebted household sector would experience intense distress as the inflation adjusted value of its debt burden increased. Even those consumers without debt would defer spending in the expectation that prices would fall further. A deflationary spiral is very difficult to break, as Japan found in the 1990s.

The Bank should give a decisive indication that it intends to prevent such a disaster. The aim of meeting an inflation target, moreover, is to foster business conditions that are conducive to growth and employment. In today's intensifying recession, that goal requires a big monetary stimulus. Even so, there are two reasons for cutting rates by no more than a point this month. First, the lower level of interest rates is bounded: the Bank can cut rates only to zero. It may do so next year, in stages; but it should retain some room for manoeuvre and so cut rates progressively. Secondly, the weakness of sterling - partly reflecting the deterioration in public finances - is a constraint and may become a problem. The taxpayer's newly acquired exposure to the banks makes it vital that international investors retain confidence in the currency.

The position of the banks is likely to be the main issue in today's MPC debate. A cut in official rates would normally feed through into the rates that banks charge their customers. But these are far from normal times. Banks are hoarding cash rather than lending it, for fear of intensifying their exposure to bad debts. They will resume lending only when they can be confident that they have built up sufficient reserves. But the underlying problem of the entire Western economy is that banks do not know with any accuracy the value of the assets that they hold.

Restoring the financial system will take time. The banks need to recover confidence in their own operations, which will involve not just an asset inventory check but a cultural overhaul. Only then will we see the tentative resumption of interbank lending and the easing of the credit markets. In the meantime, policymakers may have to inject more liquidity into the system. Cutting rates should help to encourage lending, by making capital cheap - and it must be done today.