It remains uncertain how long it will take the economy to start to recover, Bank of England governor Mervyn King has warned business leaders.
He said recent policy actions would boost demand, output and employment, but added economic policy lags were “notoriously long and unpredictable”.
Addressing the CBI during his first major speech of 2009, he added that a “pronounced contraction” was under way.
He said the priority was to fix the banking system so lending could resume.
“The contraction of lending to ordinary viable businesses – your businesses – is threatening to drive the economy further into recession,” he said in his speech to the CBI in Nottingham.
On Monday the government announced a second package of measures aimed at encouraging banks to lend more.
In referring to those steps, Mr King said they were not designed to “protect the banks as such”, but “designed to protect the economy from the banks”.
It is clear that policy did not succeed in preventing the development of an unsustainable position
Mr King said the sharp rise in debt from the early 1990s to the financial turmoil in 2007 had prompted the total debt to almost double, relative to GDP.
He defended the Bank of England’s policies, saying: “The Bank did not stand idly by during this period”
He said it had regularly underlined the risks posed “by the growth in the size and complexity of the financial sector”.
However, he added: “It is clear that policy did not succeed in preventing the development of an unsustainable position.”
In the past year the risks taken by the financial sector had become “painfully apparent”, he said.
Worries over the future of the UK’s finance sector have intensified after Royal Bank of Scotland predicted losses of the £28bn on Monday, prompting fears that it could be nationalised.
Uncertainty over the banking sector has sent shares sharply lower, hitting both RBS and the newly formed Lloyds Group.
The speech comes during a week in which a number of figures are being released and watched closely as indicators of the state of the economy.
Data on Tuesday showed that consumer price inflation fell sharply in December to an annual rate of 3.1% from November’s figure of 4.1%, raising concerns over the possibility of deflation.
And jobless data to be issued on Wednesday is tipped to show a rise in unemployment claims in December.
Data issued on Friday is expected to show that the UK economy shrank for the last quarter of 2008 – the second consecutive quarter of negative growth – which would technically mean the UK had already entered a recession.
Looking ahead, Mr King said there was an inherent contradiction between short- and long-term needs.
“Spending now supports the economy, but in the long run we need to save more and borrow less. Public borrowing sustains spending, but in the long term it needs to fall.”
Similarly, while interest rates have fallen to unprecedented levels – standing at 1.5% after another cut earlier this month – in the long-term they will need to rise to more normal levels, he said.
As well as interest rate changes, he said the bank would consider “a range of unconventional measures” to boost the amount of credit firms could access and the amount of reserves held by commercial banks.
While the government has taken steps to encourage lending, he warned: “There is a fine dividing line between helping to oil the wheels in markets which are temporarily impaired, and artificially supporting markets in which there is no underlying demand.”