LONDON (Reuters (LSE: TRIL.L - news) ) - The economy is slowing and has to do so to help cool inflation, Bank of England Governor Mervyn King said on Wednesday.

In his annual Mansion House speech to City of London (LSE: CIN.L - news) bankers, King repeated it was still unclear where interest rates would have to go to get inflation back to the two percent target but said the Bank would take whatever action was needed.

"The rise in commodity prices cannot, by itself, generate sustained inflation in the United Kingdom unless we allow it. We will not. So although inflation in the UK will rise in the short term, inflation will then fall back," King said.

"We believe that a slowdown in the economy this year, creating a margin of spare capacity, will be necessary to dampen price and wage pressures and ensure that we fulfil our remit by returning inflation to the target."

King's comment will offer little comfort to those analysts still predicting an interest rate cut this year, though he noted the economy was already slowing "quite sharply".

Nor was there any clear indication market expectations for higher borrowing costs were about to be validated.

"Where Bank Rate will ultimately need to move to bring inflation back to target is impossible to judge now," he said.

Inflation spiked to 3.3 percent in May -- its highest level since the central bank was given the power to set interest rates and forcing King to pen a letter to the government explaining how he plans to cool price pressures in the economy.

King said on Wednesday that rising household bills would squeeze consumers' disposable incomes which would affect consumer spending and the housing market.

"Lower demand in the high street will go hand in hand with lower demand in the property market," he said.

The housing market, he said, was being "severely" hit by banks tightening their lending criteria in the wake of the credit crunch.

"Once the adjustment in the financial sector is complete, banks will be able to resume lending," King said. "But the era of cheap mortgage finance that underpinned the housing market in 2006 and the first half of 2007 is over."

He said it was reasonable to expect the ratio of house prices to earnings to fall back, but not to previous averages.

(Editing by Ron Askew)