Although figures released yesterday showed that unemployment was at its lowest for18 years, the Bank also warned that the level was probably below its "natural rate" - suggesting that jobless totals would have to rise to help keep inflation down.
The warning by Mervyn King, deputy governor of the Bank, took the gloss from the "good news" of falls in both earnings growth and unemployment, and provoked angry responses from both Labour MPs and the unions.
Labour MPs are preparing a sustained campaign in the run-up to the annual Labour party conference in October to urge the Chancellor to change the terms of reference for the independent monetary committee of the Bank of England.
"There is growing nervousness and anxiety because of these predictions of increasing unemployment," said Andrew Mackinlay, one of the more outspoken Labour MPs. "The Chancellor has handed to this independent committee the tools, without the remit to be sensitive to employment. That is causing considerable concern."
John Prescott, the Deputy Prime Minister, has stood by Gordon Brown this week in defending the Chancellor's strategy for the economy, but there is likely to be increasing disquiet among cabinet ministers if the target of reducing inflation is seen to ignore the plight of the unemployed.
David Blunkett, the Employment Secretary, rejected warnings that Britain was on the brink of recession. He said the unemployment figures were "very good news indeed", and added: "This really does establish a rational balance into the argument - it doesn't suggest that all the problems are over.
"What we are looking for is stability with sensible growth and we are getting it. The Bank are right to be cautious and we are right to be optimistic."
The Bank of England yesterday said that underlying inflation would rise above the 2.5 per cent target next year, partly due to recent strong growth in earnings and the prospect of a national minimum wage. The Bank has also cut its forecasts for economic growth, and Mr King said yesterday that there was now a one-in-eight chance of a recession next year.
"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 deputy governor refused to rule out another hike in interest rates, saying that to do so would be "dishonest".
Despite Mr King's refusal to rule out a rate increase, the consensus in the City is now that rates have peaked. However, few forecasters think that rates will begin to come down until well into next year, despite the pleas for a rate cut from industry leaders and from unions.
Ken Wattret, at Paribas, said: "Talk of a cut in rate by year-end looks rather premature."
David Walton, at Goldman Sachs, added: "We remain confident that the peak in interest rates has been seen, although interest rates are likely to remain on hold for the rest of 1998."
Yesterday's unexpectedly sharp fall in earnings growth has lessened the risks of another rate rise, economists said. But July's fall in unemployment prompted some in the City to speculate that the rate of earnings growth could pick up again later in the year.
Kevin Darlington, at ABN Amro, said: "Pay growth remains well above the Bank's 4.5 per cent tolerance threshold and, with unemployment continuing to fall, it remains premature to talk of rate cuts."Reuse content