Leading US shares tumbled last night after the Federal Reserve said that the American economy could slow to the brink of stagnation this year, but signalled that rising inflation may prevent more cuts in US interest rates.

In a drastic downgrade to its assessment of American prospects, the Fed revealed that it now expected US growth to slow to between only 0.3 per cent and 1.2 per cent this year — sharply down from its previous projection of 1.3 per cent to 2.0 per cent.

The bottom end of the Fed’s new, bleak forecast would mark the weakest year for the US economy since the depths of the last recession in 1991 and spell a likely technical recession as growth all but stalls. The central bank also sounded a warning that US unemployment was set to rise “significantly” this year, to a rate as high as 5.7 per cent, from 5 per cent now, as it blamed soaring energy costs, the housing slump and the credit crunch for deepening economic woes.

Yet the Fed jolted Wall Street as it coupled its alert over faltering growth with a sharp increase in its forecast of US inflation and indicated that its anxieties over price pressures made it loath to cut interest rates any further.

The Dow Jones industrial average extended losses in late afternoon trading and fell more than 200 points in the wake of the news from the Fed.

The Fed forecasts that US headline inflation will climb to an annual rate of 3.1 per cent to 3.4 per cent — a percentage point above its previous projection. The central bank tempered that grim view with a much more modest increase in its forecast for its favoured gauge of “core” inflation, excluding energy and food costs, raising this by only 0.2 points, to a range of 2.2 per cent to 2.4 per cent. That remains above its preferred 2 per cent ceiling, however. With the Fed also releasing minutes of its April meeting reporting that it saw last month’s quarter-point cut in US interest rates to 2 per cent as a “close call”, nervous markets swiftly concluded that fresh rate cuts were being pushed from the agenda, triggering a sharp sell-off of shares.

Investors were already anxious that the Fed’s inflation worries would thwart further cuts in interest rates and that concern was strongly reinforced by last night’s developments.

Minutes of the Fed’s rate-setting Open Market Committee showed that it felt that it was “no longer appropriate” for its statement announcing last month’s rate cut to highlight so-called “downside risks” to growth.

The record also showed that several FOMC members argued that further rate cuts would be inappropriate. A “significant weakening” in the outlook would be needed to justify further Fed action, these members insisted.

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