By Steve Schifferes
Economics reporter, BBC News
The Bank of England has turned much more gloomy in its latest forecast for the UK economy - in a clear sign that damage from the US sub-prime crisis will not be contained just to North America.
In its first report since the August credit crunch, the Bank says it expects a sharp slowdown in UK domestic growth in the next year - and higher inflation as well.
It hopes that further rate cuts, and a fall in the value of the pound, which could boost exports, may bring UK growth back up to its long-run average by 2009.
But it is worried about maintaining its credibility as an inflation-fighter, with inflation expectations not changing despite higher price growth expected over the next year.
Mervyn King, the Bank's governor, warned that there was a high degree of uncertainty in their forecast this time, and that most of the risks to the economy were that things might get worse.
The governor refused to call the situation stagflation, which is the combination of a recession and high inflation, saying things were much worse in the l970s when rising oil prices and spiralling government spending pushed the UK economy deep into recession.
But he acknowledged that "certainly compared with the very small movements we've seen in the last 10 years this looks like a very sharp slowdown".
However. he added it was not "that sharp" and that the Bank's monetary policy committee (MPC) would do everything it could "to ensure that growth returns to its average rate" as well as "inflation returning to its average rate."
In truth, the Bank is now engaged in a delicate balancing act, trying to weigh the risks of inflation against the risks of a slowdown in an increasingly unfavourable international economic environment.
Mr King said that it was difficult to know how hard households would be hit as the credit crunch intensifies, which is cutting back the supply and increasing the cost of loans to individuals and businesses.
"We have seen without any doubt a tightening of credit conditions in terms of bank lending rates and the quantity they are willing to lend," he said.
Other "negative demand shocks" that could make things worse included a collapse in share prices, which Mr King judged not to have factored in the "re-pricing of risk", and a big drop in house prices, which Mr King said were already showing signs of slowing.
Both of these factors could make households feel less wealthy, and encourage them to save more rather than spend more, hitting consumer demand further.
Small firms which rely on banks to lend them money for investment may also find it more difficult to get cash, and property investment, both commercial and residential, could fall back sharply.
Analysts said that the gloomy forecast made it highly likely that the Bank would continue to cut interest rates, which markets expect to fall by half a percentage point by the end of next year.
A bigger fall than expected in the US economy next year could also put further downward pressure on UK growth.
The Bank faces a difficult dilemma, however, because it also expects inflation to remain at about the central target of 2% for at least a year.
Inflationary pressures are being driven by high oil prices, which are approaching $100 a barrel, as demand from developing countries, especially China, continues to soar.
The Bank is also worried that inflationary expectations - the level at which ordinary people believe inflation will be in the future - have not come down since the summer when inflation spiked sharply.
"We haven't seen inflation expectations fall back as much as might have hoped when actual inflation fell back," Mr King said.
Mr King said it was much too soon to be confident that the energy shocks were over, and commodity prices could increase even further.
However, the Bank is hoping that the sharp slowdown in growth will limit the inflationary damage and it is forecasting price growth to return to the government's 2% target by 2009.
Another risk for the Bank is a too-sharp and too-quick devaluation of the pound, which could also boost inflation.
Mr King said that the pound had already started to fall relative to all of the UK's trading partners, even though it was rising against the dollar.
This could have the advantage of boosting UK exports, especially to the eurozone, which could play an important role in "rebalancing" UK growth as domestic demand slows down.
But Mr King admitted that so far there had been little sign of an export-led boom in the UK, although that was already becoming evident in the US.
Financial sector sound
Mr King also downplayed suggestions that the UK downturn would be steeper than in other countries because of the large size of the UK financial sector.
He argued that the effect of the financial sector slowdown was going to be felt much more in London than the rest of the country.
And Mr King said that the £100bn of profits retained by the big five UK banks gave them a cushion which would underpin the soundness of the banking system.
He added that the recent losses in the banking sector, while large, were in line with what the Bank had been expecting since August.
But he agreed that the lack of transparency and the uncertainty over the size of the loses was still spooking the markets.
"The sooner it is possible to obtain transparency the better. But there no point in banks rushing to put out a number, only to have to revise it a few weeks later," he said.