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The Bank of England yesterday admitted for the first time recession was a real risk for the economy and that inflation would stay above the Government's official 2 per cent target until 2011.
The Governor of the Bank, Mervyn King, said: "For the time being, at least, the nice decade is behind us."
He indicated inflation could rise further, restricting still more the Bank's ability to reduce interest rates to deal with the threat of a slump.
Of the Bank's already heightened prediction of price increases, King said: "There is considerable uncertainty ... because it rests on assumptions about the magnitude and timing of further rises in domestic gas and electricity prices which are extremely difficult to anticipate accurately. Nevertheless, it is likely that, with inflation above 3 per cent for several quarters, I will be required to write a number of open letters to the Chancellor over the year."
The Bank forecasts inflation will peak at about 4 per cent this autumn.
But rising inflation is no sign of a boom. The Bank's quarterly Inflation Report of likely outcomes for the economy shows a roughly 15 per cent chance of negative growth towards the end of this year and in 2009.
"We are travelling along a bumpy road as the economy rebalances. Monetary policy cannot, and should not, try to prevent that adjustment."
That the economy could actually shrink for the first time since the recession of the early 1990s was acknowledged for the first time. "Our central projection is for a sharp slowdown of growth and it is quite possible that we may get a quarter or two of negative growth. Recession is not our central projection, although clearly further shocks could push us in this direction."
Contrasting with that pessimism, the Treasury and Alistair Darling say the economy will bounce back to growth of between 2.25 and 2.75 per cent next year.
The Bank sees the most likely scenario for growth hovering around the 1.5 per cent mark - in line with the general consensus among independent forecasters. Such a slowdown would wreck the public finances and breach the "sustainable investment rule" which aims to limit public sector net debt to 40 per cent of gross domestic product.
The combination of high inflation and low growth - dubbed "the new stagflation" - is making the task of the bank's Monetary Policy Committee tough.
Caught in the dilemma of taming inflation by raising rates and then provoking a slump or of cutting rates to keep the economy running but embedding inflation through raised expectations and higher pay demands, the Bank seems inclined to do nothing. A much-heralded quarter percentage point cut in Bank rate next month is likely to be cancelled. The Bank may start to mirror the European Central Bank, which has been in a similar quandary and has held rates since June.
Over the past decade, the Monetary Policy Committee has failed to stay within 1 percentage point of the 2 per cent target for only one month - April 2007. Now the target won't be seen again for three years.
But it remains formally in place - "now is not the time" to change the target, argued King, though he did hint that he would prefer to see house prices included in the consumer price index.
The Office for National Statistics said unemployment is rising, by 14,000 on the quarter, even as the rate remained constant and the number of people in work went up.
As for the global economy, the managing director of the IMF, Dominique Strauss-Kahn, said: "It's too early to know if the financial crisis is really behind us.
"How long will the slowdown last? I don't see a recovery before 2009."
- INDEPENDENT
