BRITAIN'S ECONOMY faces a year of stagnation and the downturn could be acute enough to send inflation below target in two years' time, the Bank of England signalled yesterday, reviving hopes of interest rate cuts.

In its latest quarterly forecasts, the bank projects that inflation will peak at about 5 per cent in the next few months, but fall slightly below 2 per cent in the medium term, based on market expectations of roughly unchanged interest rates.

"It may still - just - be summer, but there is a feeling of chill in the economic air," Mervyn King, the Bank's governor, said.

"The next year will be a difficult one, with inflation high and output broadly flat."

Investors interpreted the report as dovish and economists said they now expected earlier rate cuts. In foreign currency markets, the British pound fell sharply against the dollar in the expectation of lower interest rates to come.

But the bank, whose projections have consistently undershot inflation's trajectory in recent months, stressed that the balance of risks to its inflation forecast was "significantly on the upside", suggesting it wants to leave its options open.

A near-term rise in inflation, to 5 per cent, is next to inevitable, ­following price rises already announced by utility companies. Then inflation should ease as demand weakens and prices for imports, food and energy stabilise.

Uncertainties around the medium-term projection on prices were bigger than usual, the bank said, underlining the risk of high inflation persisting if wage and price setters came to view it as normal.

Michael Saunders, an economist at Citigroup, said these uncertainties meant policy was "of necessity a bit more myopic", expressing doubt "that the would cut rates quickly, in the next few months, unless the economy appears to be heading for depression".

Whatever the path of monetary policy, the forecast for stagnation is dismal, carrying the implication that growth might well contract for one or more quarters. - ( Financial Times service)