Mervyn King said: "We are now moving into a difficult stage of the economic cycle - more difficult than at any point since the inflation target was introduced."
The Bank's central projection in its latest inflation report has the underlying rate of inflation falling to the 2.5 per cent target in the coming months, but rising to almost 3 per cent next year, before falling back to target toward the end of the two-year forecasting period. In the last inflation report in May, the central projection was that RPIX - the underlying rate of inflation - would fall back to target by the end of 1998.
"The MPC believes that although there may be a temporary rise in inflation over the next year, looking ahead to the forecast horizon [2 years from now] the target will be met," said Mr King.
He added that there was a one-in-three chance underlying inflation would hit 3.5 per cent, the level at which the MPC must write to the Chancellor explaining what went wrong.
The Bank downgraded its forecast for economic growth, and Mr King warned that there was a one-in-eight chance that GDP growth would turn negative in 1999.
Both the inflation forecast and the output forecast assume interest rates remain on hold over the forecasting period. Mr King refused to confirm that UK interest rates had in fact peaked, and City economists warned that unpleasant surprises on the earnings front or a sharp depreciation in the exchange rate could see the Bank raise rates again.
"It would be dishonest of me to give an assurance that interest rates will only go down," said Mr King. "When and where interest rates move from now will depend on how far and how long inflation is likely to remain above target."
The August inflation report received a mixed response in the City. Some said the tone was suggestive of an easing of policy; others that the report was more hawkish than expected; while a third contingent said the Bank had tacitly admitted it made a mistake by delaying rate hikes.
Geoffrey Dicks at Greenwich NatWest said: "The forecast that inflation rises over the next year to a peak of 2.8 per cent is an admission of failure."
He added that the minutes of July's MPC meeting - also released yesterday - recognised that early inflation forecasts "were optimistic".
The July minutes - which showed that the committee had voted unanimously to keep rates on hold - surprised the City which had been expecting a more finely balanced vote.
However, City commentators were quick to assert that the minutes did not mean the MPC was now united in its view of the UK economy. Rather, these suggest that the MPC decided to adopt a "wait and see" approach in the hope that another month of data would clarify economic trends. August's rate meeting was likely to be a far closer call.
The Bank said there were a number of reasons why it decided to up its inflation forecast, including the impact of the national minimum wage, which is likely to have a "small temporary effect on inflation."
The other factors were the higher-than-expected earnings figures, weakening private sector investment growth, and higher government spending, although the inflationary impact of the new spending plans was said to be small.Reuse content