Families have been warned to expect a sharp fall in living standards as the Bank of England grapples with soaring inflation.
The Bank’s governor, Mervyn King, said a dramatic increase in energy bills, rising food prices and dearer imports would push the rate close to 4 per cent before the end of the year.
Mr King added: "As those price increases feed through to household bills, they will lead to a squeeze on real take-home pay, which will slow consumer spending and output growth, perhaps sharply.”
The Bank added to the gloom by predicting growth could slow to just 1 per cent this year - well below official Government forecasts - as banks hit by the credit crunch tighten up lending and consumers alarmed by falling house prices save more.
Wages are meanwhile unlikely to grow significantly as businesses come under pressure and shed jobs.
The warning came on the day it was revealed unemployment was rising at its fastest rate for two years.
The number of jobless rose by 14,000 to 1.61 million in the three months to March, the Office of National Statistics said today, with the number of people claiming Jobseeker’s Allowance climbing by 7,200 to 806,300 last month.
Policymakers are unlikely to ride to the rescue of struggling homeowners and borrowers with a swathe of interest cuts because inflation is so high.
The Bank’s Monetary Policy Committee is charged with keeping inflation at 2 per cent, but CPI is likely to remain above 3 per cent until well into next year - prompting a series of open letters from Mr King to the Chancellor explaining the rise.
Battering: Families have been warned to expect a sharp fall in living standards
The report suggests CPI will remain well above its 2 per cent target in two years’ time if rates fall up to twice more this year to 4.5 per cent as markets expect.
Even one more cut this year is by no means certain as the forecasts shows inflation undershooting the target by the narrowest of margins in two years’ time if borrowing costs are held at 5 per cent.
That means the Chancellor’s £2.7billion tax handout, announced yesterday, will be more than swallowed up by rising bills.
Jonathan Loynes, chief European economist at Capital Economics, said: "The report suggests that the MPC will not deliver the rate cuts which the news on the economy suggests are sorely needed.
"We still think interest rates will eventually fall, but a June cut now looks pretty unlikely and any further loosening will be modest in the foreseeable future - seriously bad news for the economy."
Mr King said the MPC faced an even more challenging balancing act between controlling inflation and preventing an economic slowdown than at the time of its February report.
He added that the economy was "travelling along a bumpy road" and called for patience until inflation returned to target.
But Mr King also admitted that uncertainty over oil prices and the timing of price hikes from energy companies made it "extremely difficult" to assess the situation accurately.
Gloomy: The number of people out of work and claiming benefits has risen again
Today’s forecasts, which said there was a risk that the UK’s slowdown "could be more prolonged", is the latest in a succession of miserable economic data this week.
On Monday, official figures showed factory gate prices rising at a record rate during April, while yesterday’s inflation figures showed CPI spiking at 3 per cent after its biggest monthly jump for almost six years.
But Mr King played down the risk of a recession. He said: "We might get the odd quarter or two of negative growth but that is not in the central projection."
Policymakers intervened last month with a £50 billion asset-swapping deal to help banks strengthen their balance sheets and ease the impact of the credit crisis.
Mr King added that conditions in financial markets had improved since the introduction of the Special Liquidity Scheme but "remained fragile".
He added: "The real impact of the scheme is to provide a basis for a general restoration of confidence so people will be able to deal in an unsecured way with other banks."
But the inflation report warned uncertainty in the banking system could persist for some time to come.
It added: "The adjustment in the supply of bank credit to households and businesses is likely to be drawn out, as banks take time to adjust their balance sheets.
"Moreover, uncertainty over future economic prospects is likely to reduce banks’ willingness to lend, at least for a period."
Liberal Democrat shadow chancellor, Vince Cable said the inflation figures were a "clear sign that a combination of the credit crunch, rising inflation and massive personal debt has now started to impact on the economy."
"The fact that Gordon Brown ignored the mounting economic warning signs is now looking deeply complacent," he said.
"With family budgets being squeezed ever tighter it was inevitable that there would be a knock-on impact on employment.
"The Government must face up to reality and take action now to help restore confidence if we are going to avoid a major economic slump."
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