Bank chief: Recession is a real risk

In a gloomy assessment, Mervyn King became the first such senior figure to use the "R word" and said it was "quite possible" the economy would contract this year and early next.

It came amid the fastest rise in unemployment for two years, inflation hitting three per cent and the weakest high street performance for three years. In a stark warning he said the economy was travelling along "a bumpy road" that could lead to the first recession under New Labour. The technical definition of recession is two or more consecutive quarters of negative growth, a situation last seen in 1991.

He said: "Our central projection is for a sharp slowdown of growth and it is quite possible that we may get a quarter or two of negative growth. Recession is not our central projection although clearly further shocks could push us in this direction."

Although the Bank still believes that the most likely outcome is a slowdown in economic growth to around one per cent, the mere mention of recession will send a chill through No10.

The Bank's forecast is dangerously at odds with the optimistic Treasury projection of growth unveiled by Alistair Darling in the Budget. They are still predicting growth of two per cent this year and 2.5 per cent next.

Presenting the Bank's inflation report, Mr King said there was little chance of deep cuts in interest rates for the foreseeable future because of the risk of fuelling price increases. The Bank now believes the core measure of the cost of living, the Consumer Prices Index, could stay above the target of two per cent for as long as two years.

Mr King said: "The near-term outlook for inflation has deteriorated markedly over the last three months. CPI inflation was three per cent in April, and rising energy and import prices will almost certainly push inflation up further, possibly significantly, in the coming months.

"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."

Mr King said he expects to write "a number of open letters" to the Chancellor over the next year. The Governor of the Bank of England is obliged to write to the Chancellor if the inflation rate hits 3.1 per cent.

He also warned that house prices will continue to fall this year following yesterday's revelation by housing minister Caroline Flint that prices will fall by 10 per cent "at best".

The Governor said: "We have already seen house prices starting to fall and they are likely to fall further. I don't think anyone can say how much."

The Bank has cut rates from 5.75 per cent to five per cent since December but runaway inflation will limit its ability to make further cuts. Some City forecasters were predicting rates would fall as low as 3.5 per cent next year but that now looks a remote possibility.

Mr King said that if rates are cut as much as the market wants - to 4.75 per cent and then 4.5 per cent by early next year - inflation will hit 3.5 per cent and could even reach four per cent.

Howard Wheeldon, senior strategist of City bookmaker BGC Partners, said: "Falling growth, uncertainty, stressed financial markets and rising inflation sum up the latest Bank of England inflation report. With virtually no room to cut interest rates the Bank might as well have used the word stagflation to describe the current UK economic position." Howard Archer of UK and European economic forecasters Global Insight said: "The report makes pretty depressing reading."