Guardian.co.uk

Britain's 15-year-long period of steady growth is at risk from a series of interlocking shocks that will prevent the Bank of England from cutting interest rates as the economy slows sharply, the International Monetary Fund warned today.

In its regular health check of the UK, the Washington-based fund pared its forecasts for growth in both 2008 and 2009 and warned the Bank against cutting interest rates at a time when inflationary pressure was high and the government was allowing its budget deficit to rise.

The IMF said it expected the UK to expand by 1.4% this year and 1.1% in 2009; in May, it forecast 1.75% expansion in both years.

In what it described as a 'difficult context', the fund said it was important for the Bank and the Treasury to ensure the credibility of economic policy.

Released on the eve of the latest interest rate decision from the Bank, the IMF paints a far darker picture of the UK economy than it has in recent years.

In addition to highlighting rising inflation and slowing growth, the report said the UK had been struggling with two new international shocks - the turmoil in financial markets and the spiralling cost of fuel and food.

'The combined effects of these shocks raised uncertainty, increased inflation risks and compounded the ongoing correction in the domestic housing market,' the IMF said. 'A run on Northern Rock, a medium-sized mortgage lender, raised the spectre of financial stability weakness feeding through to the real sector.'

The fund said the government was now on course to breach its 2% inflation target for 'an extended period' and was likely to break one of its two fiscal rules - keeping public debt below 40% of GDP.

'So far in 2008, evidence points to a sharp slowing in activity alongside high inflation,' the IMP says. 'Second quarter growth was weak, forward-looking indicators are gloomy, sterling money market spreads remain elevated, unemployment has edged up and house prices are falling rapidly.'

The fund said it could find little evidence that higher food and fuel prices would trigger an upward spiral in the annual increase in the cost of living as wages remained subdued. But with inflation at 3.8%, it expressed concern that the public's expectation of future inflation had edged up.

'Given the outlook for inflation and the stance of fiscal policy, (IMF) directors saw little scope for monetary easing at present'.

Following a decade of what it called 'sustained strong economic performance', the IMF said the UK was now facing 'several concomitant shocks'. It added that the policy frameworks that had 'underpinned this remarkable performance will be tested by lower growth, higher inflation from food and fuel price increases, ongoing strains in financial markets, rapid house price reversals and medium term external imbalances. The financial sector strains have also triggered a broad-based effort to reform the financial stability framework'.

The chancellor, Alistair Darling, has already said the government would allow borrowing to rise in the current downturn, even if that meant the 40% debt ceiling was breached.

The IMF said today it wanted the discipline to be retained, but there should be 'concrete and frontloaded' plans to bring debt back below 40% should the limit be exceded.