In the report, the BOE delivered a stark warning that UK faced a real risk of inflation rising well above the target rate of 2% to nearly 4% by the autumn of 2008 before the scenario improves. The inflation picture remains grim, even though the country's economic growth projections have been nearly halved.

BOE's base case scenario is that the annual CPI inflation rate is likely to rise to around 3.5%-3.7% by autumn 2008, chiefly on account of rising energy costs, provided that market projections on benchmark UK rates ring true.

However, a regulation fan chart (contained in all inflation reports) for May indicates the BOE is worried that inflation could touch 4%, a clear rise from the fan chart contained in the February inflation report.

Furthermore, the BOE projects that if UK rates are left at 5.0%, inflation could fall to the 2.0% target, while GDP growth would fall below 1% in 2008. The bleak assessment of the inflation picture makes a regulation letter from BOE Governor Mervyn King to UK Chancellor Alistair Darling a near certainty, as the CPI measure is forecast to rise above its current 3% rate seen in April.

BOE believes the UK economy is at risk of stalling. However, even though one to two quarters of negative growth are expected, the report does not suggest the UK risks going into a recession as a result of the credit crisis.

Inflation report projections suggest that GDP growth could fall to an annualized rate of 1% or below by December 2008, despite expectations of a weaker pound sterling boosting the country's exports. A recovery to around 2.5% is not expected before two years, based on the benchmark rate falling from the current 5.00% to 4.50% within 12 months.

In summation, the inflation report suggests that risks to inflation are on the upside, while those for GDP growth are to the downside, over the short to medium term. It said further that the Monetary Policy Committee (MPC) will be monitoring a range of data between now and the publication of the next inflation report in August.

"The Committee will concentrate on surveys of household inflation expectations and companies' pricing intentions, measure of inflationary pressures in the supply chain and data on wages and earnings," it said.

MPC would place particular emphasis on price and quantity of credit, asset prices, consumer and corporate spending, energy and food prices. The value of the pound sterling would also be studied in the run-up to August.

Elsewhere in the report, the BOE said both UK residential and commercial property markets were taking a hit amidst the ongoing tightening of credit availability. The central bank described the link between house price rises and consumer spending as a complex one.

The report mentions that lower house prices do not implicitly mean lower consumer spending. However, it notes that, "The impact on consumption could be further amplified if lower house prices coincided with a period of markedly lower income growth, for example if companies begin to shed labour."

At a press conference following the publication of BOE's May Inflation Report, Governor Mervyn King warned against the dangers of talking the economy into a recession. "I maintain what I said in February, that economic sentiment and mood outside London is very different and not all that gloomy," he said.

"We face an economic crisis, but it is nowhere near as bad as the 1930s depression, as sectors outside of finance and property, (considered the mainstay of the London economy), are doing better," King added.

He admitted the country may see an "odd quarter or two" of negative growth, which may lead some forecasters to say that it has slipped into a technical recession for the first time since the early 1990s.

On inflation, the governor acknowledged he is likely to have "plenty of opportunities to write letters" to Chancellor of the Exchequer Alistair Darling to explain why inflation is running so far above the 2.0% target, as short term BOE projections suggest the figure will be above 3% for most of 2008.

He stressed the Monetary Policy Committee (MPC) faces its most difficult challenge yet over the coming months, adding that inflation will return to target and UK growth will pick up, but that "patience will be required."

Despite fears expressed in the May Inflation Report that the figure could rise to nearly 4%, King brushed aside any suggestions of either changing the inflation target or the MPC's remit in managing it. "This is not the moment to change the inflation target. Changing the inflation target would not make the MPC's job any easier," he said.

He said the £50 billion special liquidity scheme announced by the BOE in April has been successful so far in stabilizing banking and financial sector confidence. However, he added that challenges persist as markets remain fragile. King described the UK's ongoing economic slowdown as an "adjustment which was needed." He added that the MPC cannot and should not try to prevent this ongoing adjustment.

Despite the Governor's comments, Howard Archer, chief UK economist at Global Insight, feels the report was "worrying and depressing" and indicative of the BOE's existing difficulties when it comes to managing monetary policy under such a difficult economic climate.

"The UK central bank faces an increasingly worrying mix of markedly slowing growth and well above-target and rising inflation, with still very tight credit conditions thrown in for good measure. Overall, the report indicates that only very limited further reductions in interest rates are likely," Archer said.

"Inflation touching or nearing 4% over the course of 2008 would complicate matters on the interest rates front, especially as the BOE has scaled back its growth forecasts and now sees GDP up by around just 1% at the end of this year before recovering fairly steadily," he added.

Archer concludes the report further dampens already rapidly dwindling hopes that interest rates will be cut from 5.0% to 4.75% as early as June.

Agreeing with Archer's thoughts, Jonathan Loynes, chief European economist and director at Capital Economics, said, "We still think interest rates will eventually fall considerably further as the economy continues to weaken and inflation concerns finally fade. But a June cut now looks pretty unlikely and any further loosening will be modest in the foreseeable future - seriously bad news for the economy."

Economists at RBS made an equally bleak assessment. Following on from a dismal labour market report earlier on Wednesday, which indicated a third consecutive rise in UK jobless claims, RBS economists said, "There is a clearer sense that the UK economy is at the turning point."

Many economists agree with BOE Governor's assessment that the UK economy faces a "bumpy ride" ahead and that the "nice decade" of record economic growth had ended.

Matthew Sharratt of Bank of America believes that restrictive monetary conditions and a slowing economy brings about a recognition that the BOE can do little to control inflation stemming from shocks external to the UK economy.

The UK market gave a muted response, with FTSE 100 remaining in positive territory, but not by very much. At 10:52 a.m. EDT on Wednesday, the FTSE 100 was trading up 29.20 points or 0.47% at 6,241.10 while the FTSE 250 was down 79.50 points or 0.77% at 10,292.60.

Mark Priest, senior trader at TradIndex, believes that were it not for oil and mining stocks, the blue chip FTSE 100 would be in the red.

"Once again, as in recent days, the mining sector is propping up the FTSE, with rumours of Chinalco taking a stake in BHP Billiton. Take away mining and the oil stocks, and we'd be in a raging bear market right now. Aside from the BOE report and sharp rise in unemployment figures, there's been further bad news in the banking sector, with Bradford & Bingley's rights issue," Priest said.

Within an hour of publication of the inflation report, the pound sterling paradoxically suffered. It dipped below the US$1.93 mark for the first time since early March. Conventionally, rising inflation boosts a currency, as chances of benchmark rate cuts lessen.

However, London-based forex traders stated that the markets did just the opposite amidst fears of a sharp UK economic slowdown, after the May inflation report highlighted some of the BOE's worries.

At 5:15 a.m. EDT on Wednesday, the pound sterling-US dollar cross fell to US$1.9399 from US$1.9427 but the British currency recovered later in the day, trading at $1.94345 at 10:17 a.m. EDT.

The inflation report also prompted market revisions to UK interest rate expectations. Simon Hayes, economist at Barclays Capital, said, "In view of the news we are changing our rate view. Having previously expected 25 basis points rate cuts in June and August, we now consider it unlikely that there will be any further policy loosening in 2008."

Looking ahead, Barclays Capital expects the benchmark rate will be cut to 4% by the end of the third quarter of 2009, adding that pinpointing the precise months in which the cuts would take place was becoming extremely difficult.

Bank of America's Sharratt said, "We still see a better-than-even chance for modest rate easing later this year. We had expected the next move to come in June but now push this out to August. Although we maintain our projection of a 4.0% trough in rates by mid-2009, we raise our end-2008 call from 4.25% to 4.50%."

By Gaurav Sharma, This email address is being protected from spam bots, you need Javascript enabled to view it , edited by Cristina Markham, This email address is being protected from spam bots, you need Javascript enabled to view it