Sean O'Grady: 'Slowflation' – the combination the Bank of England fears most

Growth will be slow but prices will be higher thanks to commodity prices rising and the depreciation of the pound

We used to call it "stagflation" – a lethal combination of rising inflation and stagnant output last seen in the 1970s. Then inflation hit 27 per cent a year, fuelled by commodity price hikes and a wages explosion. But the economy was far from booming – 2 million plus unemployed and plenty of factories and offices running well below capacity.

Things are not as extreme now as they were in those days, yet something similar seems to be happening, as world commodity prices soar and the economy here goes through a massive squeeze, thanks to the emergency Budget.

It is a puzzling time. The increase in VAT to 20 per cent next January illustrates the point perfectly. It will add 1 per cent or more to the cost of living and the Consumer Prices Index; but, paradoxically it will take spending power out of the economy (and thus bear down on inflation).

In any case, that means depressed sales in the shops, fewer orders, and even less scope for pay rises, though union resistance is growing. Partly depending on how much of that wage militancy we see next year, unemployment, now stabilised at around 2.5 million, also seems sure to head towards the 3 million mark.

The "double dip" recession seems to be getting closer, and growth will be slow. But shop prices will climb higher, thanks to commodity price inflation and the 25 per cent deprecation in the pound between 2007 and 2009. In 2008, the last time we saw this sort of commodity price boom, the CPI peaked at 5.2 per cent, and no one would be amazed if it hit that level again next year. We might call it "slowflation".

It won't be much fun for anyone except insolvency practitioners, but for the Bank of England it is the combination it fears most, a nightmare on Threadneedle Street. In its latest Inflation Report, published tomorrow, the Bank will acknowledge the extent to which the economy is becoming deranged. It will raise its forecasts for inflation, and lower growth predictions. The Governor of the Bank, Mervyn King, has already said as much.

It all leaves the Bank's policy-makers with a difficult dilemma. If they act on inflation now by raising rates they risk sending the economy into a downward spiral, just when Gorge Osborne is taking the axe to public spending and jobs – a simultaneous monetary and fiscal squeeze.

Or, in layman's terms, your mortgage bill will be going up at the same time as your taxes are, your neighbour is losing his job, your boss has told you a pay rise is out of the question, and the cost of everything from bread to petrol is going through the roof. So you'll not be spending much, and that will just make matters worse.

On the other hand, the Bank also knows that allowing inflation to become endemic – especially in wage setting – risks the worst of all worlds. History – not least the stagflation era – shows that a failure to take action early to kill inflation means far more pain later on.

Both arguments are right, and the difficulty of choosing between them has left the Bank in a state of semi-paralysis. Interest rates haven't moved since they were slashed to 0.5 per cent last March, and they haven't pumped any more money into the economy via "quantitative easing" since November.

Indeed it is a dilemma that is foxing economic policy-makers world-wide. In the United States, the Chairman of the Federal Reserve, Ben Bernanke, has been thinking aloud about the desirability of a further stimulus package. The Japanese, too, are considering a new boost to their economy. Only the Europeans, and our own coalition Government, have set their faces against a new stimulus – at least from spending or tax cuts.

Mr Osborne has made it clear he will not lift Mervyn King and his colleagues off the horns of their dilemna. He has hinted that if the economy does suffer an unexpected setback, it will be up to the Bank and the Bank alone to get things moving again. That presumably will be through a further injection of money, although the £200bn the Bank has pumped in so far has had only a modest impact. While Osborne has drained confidence from the economy with his tough rhetoric and the prospect of savage cuts, the Bank is supposed to top it up with cash.

However it brings to mind the famous quote of Keynes that the bank will be merely "pushing on a string".

All the indications from business and consumer surveys – and from the limp figures for mortgage approvals – are that credit supply to the economy remains a fundamental problem. The coverage of the banks' results last week speaks for their reluctance to support small businesses and first-time buyers alike. There seems little the Bank of England can now do to correct that, especially when it is pledged to remove about £300bn of funding and credit guarantees to the British banks.

In 2008 the Bank failed to foresee the recession and left rates too high for too long; now it can see another downturn and higher inflation approaching in 2011 and 2012. Like I say, a nightmare.