The Bank of England braced the country for weaker growth today as rocketing energy bills and tough Government cuts continue to squeeze household spending.
In its quarterly inflation report, the Bank cut growth forecasts for the next two years and warned inflation will fall back later than previously expected in 2013.
The Bank warned energy bills could surge as much as 15% this year, far ahead of its previous expectations, piling pressure on the cost of living and dampening growth.
Despite the uncertain outlook, economists said the report suggested interest rates will increase from 0.5% to 1% by the end of the year.
Bank governor Mervyn King said the soft patch in growth will be temporary but the recovery will hinge on business investment and exports. He warned the squeeze on household budgets may have further to go.
It is the fourth time the Bank has downgraded its growth forecast in the year since the coalition Government was formed.
The report reopened the debate over the severity of Chancellor George Osborne's austerity measures and the ability of the economy to withstand the cuts.
Shadow Treasury chief secretary Angela Eagle said: "Cutting too deep and too fast, as this Conservative-led Government is doing, is a vicious circle.
The Bank downgraded its expectations for gross domestic product in 2011 to around 1.7%, from about 2% in its February report. In 2012, GDP is expected to be around 2.2%, from just under 3%.
The rate of inflation, currently at 4%, is now expected to hit 5% this year and remain above the Government's 2% target throughout 2012 before falling back - but only if interest rates rise in line with market expectations from the third quarter of 2011.
The gloomier outlook reflected the impact of surging energy prices - such as crude oil in the wake of political unrest in Libya - and the impact disappointing real wages will have on spending.
The Bank has forecast inflation to fall back to about 2.5% next year. The report said this reflected an increase in VAT, as well as higher energy and import prices.
However, economists said the report highlighted the uncertainty around the path for GDP growth and inflation.
Jonathan Loynes, chief European economist at Capital Economics, said: "On the face of it, the report seems to endorse expectations of some policy tightening later this year, continuing in 2012."
However, he said weaker growth in the face of the fiscal squeeze, as well as possible falls in oil and commodity prices, could mean that inflation falls back further than the Bank expects.
Mr Loynes added: "A hike in August or later is clearly still a danger, but we stick to the view that rates won't rise either this year or next."
Downing Street said David Cameron had always made clear that rebuilding the economy would not be easy and the recovery may be "choppy".
The Prime Minister's official spokesman said Mr Cameron had stressed in a speech earlier this year the Government was not in a position to "just flick on the switch of government spending or pump the bubble back up".
But Mr King said the fiscal clampdown would limit growth in the next two years and said household spending may have further to adjust to the "significant" squeeze in real wages.
Inflation is also likely to continue to show "sharp" month-to-month movements, he added.
The governor said: "As the economy gradually recovers from a deep recession, and rebalances towards a more sustainable path, the outlook for growth and inflation is likely to remain unusually uncertain."
He also warned there was a risk that companies will resist the squeeze inflation is having on employees' incomes by lifting wages, which in turn will push inflation higher.
TUC leader Brendan Barber said: "The coalition is now a year old and has a direct hand both in the weak state of our economy and the pain that is being exerted on household incomes.
"The Government must change course or its austerity measures will prolong our poor recovery and cause an even greater decline in people's living standards."Reuse content