The Bank has to balance rising inflation with slower growth
The Bank of England says it expects the UK economy will not grow at all over the next year or so.
In the Bank's gloomiest assessment yet, governor Mervyn King said that he expected growth "to be flat" and did not rule out a recession.
He warned inflation would peak at 5%, making it hard for the central bank to cut interest rates in the near future.
However, he said that the slowing economy would eventually curb inflationary pressures.
"I think with broadly flat output, it's bound to be the case that there is a possibility of a quarter or two of negative growth," Mr King said.
In a technical definition of a recession, the economy contracts for two consecutive quarters.
Mervyn King delivers his inflation report
The economic picture has worsened since the Bank's last inflation report in May, which forecast growth to fall to about the 1% mark at the end of this year.
And the Bank's prediction is worse than the government's official forecast of growth in 2009 of 2.25% to 2.75%.
Mr King added that consumer spending and house prices would weaken, particularly because of tighter credit conditions that were expected to continue.
Earlier on Wednesday, figures had shown that the number of people unemployed in the UK rose by 60,000 to 1.67 million in the three months to June, taking the unemployment rate to 5.4%.
The gloomy outlook in the Bank's inflation report hit the pound, which fell to 22-month lows against the dollar.
Mr King said that he expected the rise in inflation would be temporary but the UK economy would go through a "difficult and painful adjustment" until the rate fell back toward the government's target of 2% in two years.
Interest rates will eventually fall very sharply once inflation pressures finally recede
"We will come through it, inflation will come down and we will resume a pattern of normal growth," he said.
"But the unique combination of food and energy price rises and the dislocation of the financial sector will make a difficult adjustment for the UK economy."
UK inflation as measured by the Consumer Prices Index (CPI) rose to 4.4% in July, its highest level since CPI records began in 1997.
Economists said the Bank's latest report indicated that interest rates were likely to remain unchanged for the next few months to bring inflation under control.
Some said the governor's lower growth forecasts raised expectations of an interest rate cut at some stage.
"The Bank of England's August Inflation Report will be seen as rather more dovish than might have been expected given the recent dreadful news on inflation," said Jonathan Loynes, chief European economist at Capital Economics.
"Interest rates will eventually fall very sharply once inflation pressures finally recede."
Over the worst?
Mr King said that banking system might sustain more losses as the economic downturn gathered momentum.
"For some institutions... they are over the worst and for other perhaps not. But I think we have certainly moved some long way down the road."
The governor stressed that the mortgage market was unlikely to ever return to pre-credit crunch levels, when 100% mortgages were commonplace.
But he rejected suggestions that the UK should follow the US example and create a government-sponsored agency to guarantee mortgages and kick start lending.
"It's the lenders who should take the risk and assess for themselves the riskiness of that lending. And what we saw in the first half of 2007 was that not enough attention was paid to monitoring the riskiness of that lending," he said.
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