Inflation is heading for a peak at around five per cent – or possibly more – in the coming months as the latest round of gas and electricity prices feeds through into utility bills, while the economy grinds to a near standstill this winter.

This is the most likely prospect facing Britain held out by the Bank of England in its latest quarterly ‘Inflation Report’.

The Bank’s governor Mervyn King described the outlook as “painful”, but temporary.

The Bank’s central projection shows inflation shooting up to five per cent by Christmas, then falling equally sharply in the Spring of next year to settle slightly below the Bank’s two per cent target in early 2010.

Meantime, economic growth is set to fall to little better than zero in early 2009 before picking up to close on the long-term trend of 2.5 per cent in the first half of 2010.

But Mr King warned “The possibility of a more prolonged adjustment in the financial sector means that in the (monetary policy) committee’s judgment, the balance of risks around this central projection is on the downside”.

The issue, he added, was not whether the economy shrinks for two quarters running – the technical definition of a recession – but whether there would be a “more severe downturn”.

“The adjustment of the UK economy to higher commodity prices and a more realistic pricing of credit will be painful,” he added.

“The next year will be a difficult one, with inflation high and output broadly flat. But with monetary policy focused on its task of bringing inflation back to target, we will come through the adjustment.”

Asked why he was so confident that inflation will return to two per cent Mr King said sternly “Because we will see that it does”.

Despite that, money markets took the relatively mild tone of the report as a signal that interest rates could start to fall by early next year. Hetal Mehta, economic adviser to the Ernst & Young ITEM Club, described it as “surprisingly dovish reading”.

Richard Lambert, the CBI’s director general and a former member of the Bank’s committee, commented “The economy is losing momentum, but with inflation set to rise to five per cent or more in the short term, there is little room for interest rate cuts in the immediate future.

“The outlook should start to look better next year, provided the impact of higher energy and food prices is contained and not passed through into the broad economy in the form of sustained inflation.

“That will require a period of wage restraint across the economy and a painful squeeze on living standards. The alternative would involve a serious risk of higher interest rates and unemployment over the slightly longer term.

“Business cycles come and go. What is important now is to establish the conditions needed for a gradual recovery in economic activity in the next year or two, powered by a slower pace of inflation, lower interest rates, easier credit condition and rising exports.”

The report described the outlook for inflation as unusually uncertain.

Mr King pointed to the unique combination of an oil shock in which the price of crude quadrupled over four years and the credit crunch starting last August. On top of that the value of the pound fell by 12 per cent more than the Bank expected in February last year, driving up the cost of imports.

On Wednesday sterling lost another two cents against the dollar falling below $1.88, as currency dealers priced in the prospect of interest rate cuts next year.

Jonathan Loynes at Capital Economics suggested the first of these could come before the year-end as the Bank becomes more concerned about the wider economy and less about inflation.