David Blanchflower, the arch-dove on the Bank of England's Monetary Policy Committee (MPC), today forecast that the UK economy is heading for an "unpleasant shock" with unemployment set to spike in October.

Sterling fell to a two-and-a-half year low against the dollar as markets digested Mr Blanchflower's comments, sending the pound down to $1.7460 — a level last seen in April 2006.

Speaking before the Treasury Select Committee, Mr Blanchflower's "doom-laden view" of the economy included forecasts the UK would "see a large rise in unemployment", to the tune of an extra 60,000 a month for "several months".

Unemployment is currently running at 1.67 million, or 5.4 per cent of the population in the three months to June.

Mr Blanchflower, who has voted to cut interest rates at every MPC meeting in 2008, was speaking alongside the Bank of England's Governor, Mervyn King, to answer questions on inflation, which is running at a 16-year high, and interest rates, which have been held for five months at 5 per cent.

Mr Blanchflower said he expects inflation to rise to 5 per cent from its current 4.4 per cent, which is more than double the Government's 2 per cent target.

He said: “I don’t think we are going to see a flat period of growth, I think we are going to see a deeper decline than others think and I think the pullback is going to take somewhat longer to come.”

In his opening statement to the cross-party Committee, Mr King said: "In the UK we face a difficult, but temporary, period during which inflation will remain high for a while and output growth at best weak.

"It would be most surprising if, next week, I were not required to write a further open letter to the Chancellor explaining why inflation is more than a percentage point away from target.

"But provided we do not impede the required adjustment, we will come through this temporary period and resume a path of normal economic growth with inflation close to target."

Mr King also said that there would be no extension of the special liquidity scheme, which allows banks to swap their hard-to-trade mortgage securities in return for Treasury-backed gilts.

The scheme, which started in April is due to end on October 22. Although, Mr King said that the Bank will set up a "permanent liquidity insurance scheme" and details are expected to be revealed next week when a consultation paper is released.

Commenting on the MPC's interest rate decisions and Britain's slowing housing market, Mr King said: “We spent some considerable time anguishing about why houses have risen so much.

"Some of the members of the committee have very convincing explanations why interest rates didn’t need to rise ... but it is very difficult to disentangle how far house prices have risen and as a result its very difficult to know how far they will fall, all we can do is to watch.”

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