Jeremy Warner's Outlook: Inflation is rising and growth is falling. Is there any way out for policymakers?

To judge by some of the language, you'd think the International Monetary Fund had joined the gloom and doom merchants now gleefully proclaiming the start of a next Great Depression. In its latest economic assessment, the IMF says the global economy is in a "tough spot", with policymakers caught between an apparently inescapable pincer movement of slowing demand in many advanced economies, and rising inflation everywhere, particularly in emerging and developing economies.

Yet despite these warnings, the IMF has actually raised its growth forecasts for the world, US and UK economies to levels which, though obviously well below the boom of last year, are nonetheless incompatible with the deep global recession the headline writers want to plunge us into.

For the world economy, the IMF has raised its forecast for this year from the 3.9 per cent predicted in April to 4.1 per cent. The UK econ-omy is forecast to grow by 1.8 per cent this year and 1.7 per cent next – up from a previously forecast 1.6 per cent for both years. The IMF has upped its predictions for the US by a similar order of magnitude, though it also expects a moderate contract-ion in the second half of this year.

The differences might seem marginal, but they are increases nonetheless, and are quite contrary to the mood of deepening gloom emanating from the financial markets. The IMF chief economist, Simon Johnson, explains the more positive tone by saying that the financial crisis is filtering through to the real economy more slowly than expected. He also points to the fiscal stimulus now coming through in the US. Is it really possible to have a banking crisis as all embracing as this one without a severe economic contraction? Maybe not, but, as the IMF forecasts suggest, the read-through is still far from certain. What is plainly true is that we are facing a couple of very difficult years for both the world and UK economies.

Next month's quarterly Inflation Report from the Bank of England is certain to show a further deterioration in the central projection for growth and inflation, with annualised growth sinking to below 1 per cent in the first quarter of next year and CPI inflation spiking up to something close to 5 per cent.

The outlook for consumption over the next couple of years looks particularly grim. More than a decade of rising disposable incomes and improvements in the terms of trade has come to an end. Both these trends are moving into reverse, with inflation, rather than disinflation, now being exported out of the emerging markets of the developing world as well as rising energy and food prices. Incomes are being further squeezed by higher levels of taxation.

Nor, thanks to the financial crisis, will there be any relief from the credit markets. As it happens, the great bulk of the growth in British household debt in the past ten years went not into consumption but housing. Even so, the present squeeze, in combination with now falling house prices, is bound to have a severely negative impact on consumption. If nothing else, it's got a whole lot more expensive to finance a mortgage, further eating into the spending pound. Yet a recession as deep as the early 1990s, let alone the mid-1970s or the years of the Great Depression, continues to seem somewhat unlikely. What might change that is an inflationary wage spiral, which is all too possible with the price of essentials rising as strongly as it is and the now striking public sector workers.

The Government is examining alternative ways of easing the pressure on the lower paid, by for instance funding tax cuts at the bottom end of the scale with tax hikes on high-income earners. Alternatively, the Government could whack the better-off by abolishing higher-rate tax relief on pension contributions.

Yet there are no easy solutions. Any such move would be politically dangerous and, as with the abolition of the 10p tax rate, likely to run into the law of unintended consequences. The Goverment's much trumpeted fiscal rules are already toast. Only pride prevents the Treasury admitting it and even on this front it may soon be adopting the Augustinian approach – please make me chaste but not yet. Robbing Peter to pay Paul won't make the already dire fiscal position any better, and in any case, won't solve the problem of an inflationary wage spiral.

If elevated levels of inflation show any sign of becoming embedded through second-round effects, the Bank of England will feel obliged to induce a more serious downturn than now seems likely. Interest rates have to be falling by the end of the year, possibly sooner, to prevent a hard landing. Inflationary pay awards would constrain the Bank's ability to deliver these cuts.

In other words, it's touch and go. Best advice? Prepare for the worst, hope for the best.