Mervyn King doesn't do hyperbole. “A feeling of chill in the economic air,” was how the Bank of England Governor described the financial climate yesterday. He might have added that the weather in August has been a little moist.

The fact is the Bank believes that the economy is looking very sick indeed and could well stop breathing next year. The list of ailments is long: rising energy and food prices, a collapse in house sales, increasing unemployment, falling business investment and a freeze in bank lending.

As a result Mr King predicted that output next year will be “broadly flat”. In Bankspeak, that means we could well see a recession where the economy contracts for a couple of quarters.

The Bank is much more gloomy than it was in May, partly because the impact of the credit crunch on the financial sector has been worse than forecast.

Moreover, it believes there is a good chance that the problems in the banking sector could last longer than expected so the balance of risks is that its projections are still too optimistic.

The huge losses resulting from the US housing meltdown have made all banks nervous about lending. And that is before they have seen much increase in bad debts from the economic slowdown.

Although many have raised huge sums from their shareholders, European banks may yet have to ask for another $70 billion to $120 billion to strengthen their balance sheets, Merrill Lynch said yesterday. Barclays and HBOS are among the UK banks most likely to need more funding, it said. In addition to the impact of the slowing economy, the banks were concerned that regulators may change the rules to force them to hold more capital. That will make them doubly cautious about new lending.

The Bank's grim forecasts will not go down well in Downing Street. And Mr King will have further irked Alistair Darling by making clear his opposition to measures being contemplated by the Chancellor to boost mortgage lending.

The Bank's short-term forecast on prices has also worsened, with inflation now expected to reach 5per cent this autumn. But, thanks partly to the expected sharp slowdown in the economy, it predicts that inflation will then fall back quickly and will be back below its 2per cent target rate in two years' time.

Although the Bank has been consistently too optimistic about inflation, traders decided the new forecasts meant it was now unlikely to raise interest rates and could cut them before the end of the year.

This further undermined the pound, which fell to its lowest level for 11 years against a trade- weighted basket of currencies. Against the dollar it fell below $1.88. The weakness of sterling should be a further boost for British manufacturers, although the impact has been disappointing so far.

The Bank's biggest worry is that inflation fails to come down as far and fast as it forecasts because inflation expectations rise. It believes that if rising prices lead to rising wage claims the resulting spiral would be particularly painful to break. But the evidence so far is reasonably encouraging. Average earnings rose 3.4per cent in the second quarter, down from 3.8per cent in the three months to May.

Unemployment jumped sharply in July, which should help keep the lid on wages and inflation expectations.

That could mean early interest rate relief from Mr King, although that will be scant consolation for the thousands who face a cold winter on the dole.

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