The Bank of England yesterday forecast UK economic output would stagnate "over the next year or so".

The Bank of England yesterday forecast UK economic output would stagnate "over the next year or so", and acknowledged the possibility of recession, as its revised medium-term inflation projection fuelled hopes of a cut in benchmark interest rates before the year end.

Sterling plummeted and gilts rose, as interest-rate futures moved in the wake of the Bank's latest quarterly inflation report to price in an 80% chance of a quarter-point cut in UK base rates to 4.75% by December and further monetary easing thereafter. Before the report, futures had signalled only a 10% chance of a rate cut by December.

The Bank of England's Monetary Policy Committee is now forecasting benchmark annual UK consumer prices index inflation will peak at or above 5% in coming months. However, as spare capacity in the economy increases with stagnation of gross domestic product (GDP), it thereafter sees a sharp fall in inflation.

Crucially, the MPC now sees inflation below its 2% target on a two-year time horizon, and falling thereafter, based on market interest rates in the run-up to the report's compilation which had assumed base rates would stay at 5% until mid-2010 with a likelihood of a quarter-point rise in the second half of that year.

The market tore up these base-rate projections yesterday, with publication of a quarterly inflation report which was significantly more dovish than expected particularly in light of Tuesday's news of a worse-than-feared surge in inflation to 4.4% in July.

The Bank's inflation report scotched, for now at least, any lingering fears that the MPC might react to rocketing inflation by raising interest rates.

Setting out the MPC's revised projections for UK economic activity, the inflation report states: "The committee's central projection is for output to be broadly flat over the next year or so, after which growth gradually recovers. But there is a risk that the slowdown may be more pronounced."

And, appearing to acknowledge the possibility of recession, Bank of England Governor Mervyn King said: "I think, with broadly flat output, it's bound to be the case that there is a possibility of a quarter or two of negative growth."

Technical recession is defined as two consecutive quarters of contraction.

King also made it plain that the Bank could do nothing to prevent the troubles to come for the UK economy.

He said: "The next year will be a difficult one It may still just be summer, but there is a feeling of chill in the economic air. The British economy is going through a difficult and painful adjustment, due to higher energy and commodity prices, and (developments) in banking, credit, and housing markets.

"This adjustment to our economy cannot be avoided and, as a result, inflation is rising and growth is slowing."

The inflation report states that "it is more likely than not that the inflation rate will rise above 5% at some point in the coming months".

Referring to the MPC's central forecast for GDP, the report says: "In the central case, GDP is broadly flat in the near term, as further increases in inflation erode the growth of households' real incomes, the reduced availability of credit also impedes household spending, and residential and business investment are held back by, respectively, the weak housing market and poorer business prospects. Net trade takes up some of the slack.

"GDP growth then picks up gradually as credit-supply conditions begin to ease, the restraining effect of higher energy and other costs on demand and output dissipates and the lower level of sterling supports net trade."

The inflation report emphasises the MPC's view that the risks on both sides of its inflation projection have increased since May.

The MPC still considers a greater-than-expected slowdown in economic demand to be the main risk of it undershooting its inflation target in the medium term. It still views a rise in people's longer-term inflation expectations, and consequently higher wage settlements, as posing the main threat of an overshoot.

Earnings data yesterday from the Office for National Statistics showed that pay pressures remain extremely muted, in spite of rampant inflation. Headline annual earnings growth decelerated from 3.8% in May to 3.4% in June - the weakest rate since August 2003.

The Bank of England inflation report urges restraint on wage settlements.

It cautions: "In order to continue in operation, companies will over time have to pass the burden of higher non-labour costs on to households. That will occur through some combination of lower nominal wage growth, higher prices and lower employment growth, implying a reduction in the purchasing power of households' incomes.

"Real pay growth has already moderated and looks set to slow further, as increased non-wage costs lead businesses to put downward pressure on labour costs in a loosening labour market.

"But if employees resist the required adjustment in real wages, that would lead to a more pronounced slowing in output and employment."

The pound was last night trading nearly three cents lower than its close in London on Tuesday against the dollar - trading just above $1.8700. It hit $1.8640 during yesterday's session - its lowest since autumn 2006.

Sterling also tumbled against the euro. The single currency was last night up about 1.4 pence on its close in London on Tuesday, trading just above 79.8p.

Economists were, in the wake of yesterday's report, less sold on a cut in benchmark UK interest rates before the year end than financial markets. A poll of economists by news agency Reuters, taken after the report was published, showed 22 of 63 now expect a cut in UK base rates by the year end.

The median probability attached to such a move, although way adrift of that in the interest-rate futures market, did jump to 40% from 30% in a similar poll taken only two weeks ago.

Economists tend to be much slower to change their forecasts of rates than financial markets.

Fifty-two of the 63 economists polled forecast a cut in UK base rates by the end of the first quarter of next year.

Jonathan Loynes, chief European economist at consultancy Capital Economics, said: "The Bank of England's August inflation report suggested that the Monetary Policy Committee is grad- ually becoming more concerned about the outlook for the economy, than for inflation. Interest rates may yet fall before year end."