Growth will slow sharply this year but there is only limited room for further interest rate cuts, the Bank of England (BoE) said yesterday.

In a hawkish quarterly Inflation Report, the Bank said that annual growth would slow to below 2 per cent, down from around 3 per cent in 2007.

Mervyn King, the Governor of the Bank, said that the possibility of a recession was “perfectly consistent with something not very far off our central projection”, but he pointed out that its forecasts were “a world away” from a severe and prolonged downturn.

Mr King said: “This will be a more difficult and challenging period than we have seen in the past.”

The Bank also indicated that hopes for steady cuts in interest rates would be dashed because of increasing inflation.

It said that cutting rates in line with market expectations, which forecast interest at 4.5 per cent by the end of the year, could cause inflation to spike to more than 3 per cent later this year and keep it above the 2 per cent target in the following year.

If inflation, at present 2.2 per cent, exceeds 3 per cent, Mr King would have to explain why to the Chancellor, something that he said was “more likely than not” to happen.

Mr King blamed rising energy costs and food prices and the effects of the credit crunch.

The weakening pound has also pushed up the cost of imports.

Karen Ward, UK economist at HSBC, said: “The BoE are broadly pointing to one or two rate cuts but not more.”

Lai Wah Co, principal economist at the CBI, said: “The Bank faces the tough task of balancing its credibility on inflation while remaining alert to risks to economic growth.”

The report came as the number of surveyors reporting house price falls reached the highest since 1992.

A balance of 54.7 per cent more surveyors recorded falling rather than rising prices in January, up from 49.1 per cent in December, the Royal Institution of Chartered Surveyors said.

Goldman Sachs has predicted a 5 per cent fall in house prices this year and a further 2 per cent in 2009.

Figures released yesterday showed that unemployment fell in January for the sixteenth month in a row.

The number of people claiming unemployment benefit fell by 10,800 last month, more than twice the amount expected.

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