The Bank of England sounded a stark warning last night that the economy faced its most testing period for a decade and that the persistent danger of inflation left it boxed-in over potential action to stave off a severe downturn.

In a grim assessment of the conflicting economic pressures buffeting Britain, Mervyn King, the Governor of the Bank, said that the country could endure a “possibly quite sharp” slowdown this year as a weakening housing market and consumer spending continued to limit growth.

He gave warning that the Bank was hamstrung in its ability to counter the slowdown because soaring food and energy costs were putting pressure on inflation.

“To put it bluntly, this year we are probably facing a period of above-target inflation and a marked slowing in growth,” Mr King said. “You might think we have now entered a not-so-good period.

“The next year will pose economic challenges for all of us, more so than at any time since the Bank was given its independence in 1997.”

The Governor used the hard-hitting speech in Bristol to ram home the message that the Bank may be powerless to prevent a marked downturn.

“We have little control over the strength of the economic winds buffeting our economy,” he said. “We cannot avoid some volatility in the short run and it is important that everyone understands the limits to the ability of central banks to smooth the economy.

“In 2008 it is likely that a less buoyant housing market will go hand in hand with slower growth of consumer spending. In the short run, that will slow economic activity, possibly quite sharply.”

His acceptance that the tightening of borrowing conditions imposed by lenders “is unlikely to be short-lived” will be seen as confirmation that a further quarter-point cut in base rates next month remained very likely.

However, his tough stance on inflationary risks dampened prospects for aggressive cuts this year and quashed hopes that the Bank might follow the dramatic cut in interest rates made by the US Federal Reserve.

Mr King said that inflation was being fuelled by the 10 per cent drop in the value of the pound since August, boosting import bills.

He said: “2008 is likely to see higher energy prices, higher food prices and, with a lower exchange rate, higher import prices, pushing inflation above 2 per cent."

This meant that the Bank faced “a difficult balancing act in the course of 2008”, but Mr King said that the big adjustments taking place in the economy and credit markets were necessary and “not a process that we should try to reverse”.

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