Bank of England governor Mervyn King warned of "a choppy recovery" for the UK economy today as he braced households for slower growth and stickier than expected inflation.
The Bank's latest forecasts showed slower growth than previously thought next year as Chancellor George Osborne's emergency Budget kicks in, while inflation will stay above the Bank's 2% target until the end of 2011 due to next January's VAT hike.
Households will also be squeezed by tighter credit conditions as banks repair their balance sheets, the report added.
The latest gloom from the Bank comes after recent surveys showed a sharp slowdown in high street sales, falling house prices and consumer confidence at its lowest for more than a year.
The governor said the impact of the financial crisis would fade only gradually, with the problems in the banking sector "likely to mean a choppy recovery".
The Bank added that household disposal incomes would be squeezed as a result of the deficit-tackling measures, with some companies likely to face lower public sector demand.
Households have also become more pessimistic in recent months amid persistent fears over unemployment and subdued wage growth, the report added.
The Bank's monetary policy committee has already slashed interest rates to a record low of 0.5% and pumped £200 billion into the money supply, but its latest inflation forecasts signal that further action could be on the way.
The projections show consumer price index inflation falling more slowly because of the VAT rise, although CPI still undershoots the Bank's 2% target in two years time - even without any withdrawal of emergency support measures for the economy.
The Bank of England sees growth next year at around 2.5%, compared with 3.4% in its May report. The figure rises to 3% in 2012.
Mr King shrugged off accusations that the MPC's projections were too optimistic and said that output growth over the last 12 months had been slightly stronger than last year's projections.
He said: "A year ago, a lot of people were saying we were being too optimistic, but output has actually been stronger.
Asked how much the Government's emergency Budget and increased fiscal consolidation would impact on the moderated forecasts in growth, Mr King replied "not much".
The governor added that lending terms to business had worsened significantly since the financial crisis began, but he refused to blame the banks.
He said: "Banks are not being awkward or bloody minded in their attitude, they are facing higher costs of funding... it is not a question of blaming people, this is a direct consequence of the financial crisis that occurred."
Howard Archer, chief UK economist at IHS Global Insight, said policymakers were unlikely to raise rates soon.
"The Bank of England report and Mervyn King's accompanying comments reinforce our view that the bank is most likely to keep interest rates down at 0.5% during the rest of 2010 and through the early months of 2011 at least, given likely bumpy and overall muted recovery in the face of significant headwinds.
"Furthermore, it is abundantly clear that interest rates are set to remain very low for a considerable time to come, regardless of when they first start to rise. Monetary policy will need to remain loose for an extended period to offset the impact of the major, sustained fiscal squeeze."
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