The Bank of England has signalled that the scope for further cuts in interest rates is limited, despite slow growth, after it forecast higher inflation.
The Bank predicted that UK growth would slow sharply to less than 2% by the end of 2008, from about 3% at present.
But the Bank also said it expected inflation to remain above the government's target of 2%, and forecast it could rise as high as 3%.
This could mean fewer interest rate cuts than financial markets expect.
"The Bank of England's February Inflation Report has given a pretty strong signal that, for now at least, the Monetary Policy Committee does not expect to cut interest rates as far and as fast as the markets currently anticipate," said Jonathan Loynes at Capital Economics.
Many economists have said they expect interest rates to fall as low as 4.5% by the end of 2008 from 5.25% currently.
Bank governor Mervyn King said that the bank faced a "difficult balancing act" and it was "the outlook for inflation, in the medium term" that the central bank's Monetary Policy Committee (MPC) would remain focused on.
Mr King added it was likely that the rate of inflation would hit 3% by the middle of this year, which would require him to write a letter of explanation to the government.
However, he anticipated that the rise in inflation would be temporary and would be due to increases in imported energy and food prices that were unlikely to recur.
"This is not something you can offset by asking for higher wages," he said.
January's consumer prices index (CPI) inflation figure rose to 2.2%, up from 2.1% in December and the highest rate since June.
The increase was due to rising fuel and food prices, and it kept the CPI figure above the government-set target of 2%.
Mr King's comments come amid increasing signs that the disruption in global financial markets, a strong pound against the US dollar, and earlier increases in the interest rates are all creating problems for the UK economy.
The Bank cut UK interest rates last week to 5.25% from 5.5% in an attempt to prevent a major slowdown in the economy.
Mr King said falls in house prices were "conceivable" and it was reasonable to expect house prices to be flat for some time.
"The central view in this forecast is, looking several years ahead, there's no reason to expect house prices to be markedly above where they are now," he said.
However, Mr King said that while the picture painted by those working in financial and housing markets was bleak, the mood outside London and in other areas of the economy was not as bad.
"Don't be taken in by too many of the analysts who are perhaps coloured somewhat by the environment within which they have to work in the financial sector. Getting outside is a pretty good antidote to that," he said.