Inflation to soar and wages to fall: Mervyn King's message of economic gloom

He said inflation would rise to between 4% and 5% over the next few months, concluding a gloomy day in which it was revealed that the economy shrank unexpectedly in the fourth quarter.

King warned that rising unemployment and declines in real earnings will hit spending in the private sector, with the public sector hammered by government spending cuts.

But it was inflation that was the his biggest immediate headache.

"We are experiencing a period of uncomfortably high inflation," he said in a speech at Newcastle's Civic Centre.

"With the standard rate of VAT rising to 20% this month, and recent further increases in world commodity and energy prices, inflation is likely to rise to somewhere between 4% and 5% over the next few months, before falling back next year."

King also warned that real wages will plunge back to 2005 levels as prices soar and cuts take effect.

The 0.5% plunge in GDP between October and December was blamed on severe weather before Christmas which triggered a drop in demand for the services sector, which makes up more than 75% of the economy.

Analysts warned the decline - the first since the third quarter of 2009 - seriously damaged prospects for the economy as it takes the strain of the Government's cuts and tax rises. It also raises the prospect of stagflation, a period of high inflation coinciding with a stagnating economy.

King told the accountants' business dinner that the figures "remind us that, as I said last year, the recovery will be choppy".

While the economy was "well placed to return to sustained, balanced growth", he outlined strong headwinds facing the economy in 2011.

This morning Shadow Chancellor Ed Balls blamed the Coalition for "going too far" with its spending cuts.

"The result is where we had the economy growing and unemployment falling, that is now reversed," he said.

"We were told by the Conservative Chancellor that if you cut spending and get the deficit down faster, that will make the economy stronger. Unfortunately it is having the opposite effect, the economy has become weaker."

King also said it was also wrong to believe the Bank's Monetary Policy Committee could have prevented the current price shock.

"The idea that the MPC could have preserved living standards, by preventing the rise in inflation without also pushing down earnings growth further, is wishful thinking," he said.

"If the MPC had raised Bank Rate significantly, inflation might well have started to fall back this year, but only because the recovery would have been slower, unemployment higher and average earnings rising even more slowly than now."

His move to increase Bank inflation expectations yet again will heap further pressure on the MPC.

There have been calls for action after inflation rose to 3.7% in December, far higher than the Bank's 2% target.

Fellow MPC member Andrew Sentance - who has repeatedly voted for a quarter point rate rise to ease inflation - said in a speech last night the "time has come to act" as he cautioned price pressures were not one-off.

GDP figures will have taken some of the heat off the Bank to increase rates, but they also highlight the difficult situation faced by policymakers.

With the economy veering dangerously close to stagflation, the Bank is hampered in its ability to address either growth or inflation without making the other worse.

King took last night's speech as an opportunity to defend himself against critics. He maintained his belief that rising inflation was largely down to temporary factors and would still fall back "quite sharply" next year.

He said with wider factors such as import and oil prices stripped out, domestic inflation has been close to zero over the past four years.