No rate cuts for two years, King hints as inflation heads towards 4 per cent

The Bank of England indicated that there is not likely to be another cut in interest rates for two years, as it forecast that inflation will reach 4 per cent this autumn.

The Bank admitted for the first time yesterday that 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 price rises would lead to "a squeeze on real take-home pay, which will slow consumer spending and output growth, perhaps sharply".

Rising inflation is not a sign of a booming economy. In its quarterly Inflation Report, the Bank's "fan chart" 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 in size 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 difficult. 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 of England may start to mirror the European Central bank, which has been in a similar policy quandary and has left rates on hold since last 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. Nonetheless, it remains formally in place – "now is not the time" to change the target, argued Mr King, though he did hint that he would prefer to see house prices included in the consumer price index.

Mr King indicated that inflation could rise further. Of the Bank's already heightened prediction of price increases, Mr 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".

Mr King said: "For the time being, at least, the nice decade is behind us."

On the credit crunch, Mr King pointed out that Libor and the credit default swaps market had moved in a favourable direction over the past six weeks, and that the crisis seen in March was now over, with the rescue of Bear Stearns, further liquidity injections by the world's central banks and the Bank of England's own £50bn special liquidity scheme starting to make an impact on confidence in the banking system. The Bank's executive director for markets, Paul Tucker, said that "some risk appetite is returning, notably in the acquisition of assets".

Mr King made much of the relatively benign outlook for the labour market, and even suggested that the return of migrants to Poland and other eastern European nations may keep the jobless numbers from climbing.

The Office for National Statistics said yesterday that 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: "Probably a large part of the financial crisis is behind us, but it is difficult to know if everything is behind us. I don't see a recovery before 2009."