LONDON -- The British economy could shrink for a quarter or two and inflation may near 4 percent this year, the Bank of England said on Wednesday, in its bleakest forecasts since the Labour government took power in 1997.

Economists said the spike in inflation above the central bank's 2 percent target, caused by soaring food and energy prices, meant interest rates couldn't fall too quickly, prolonging the pain for the economy.

This spells trouble for Prime Minister Gordon Brown. He is banking on a quick recovery after voters, fretting about the rising cost of living and falling house prices, pushed his Labour Party into third place in local elections this month.

Bank of England Governor Mervyn King said economic growth might grind to a halt, but probably not for long.

"It is quite possible that at some point we may get an odd quarter or two of negative growth, but recession is not the central projection at all," he told a news conference after the BoE published its quarterly economic forecasts.

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More Britons may also soon start worrying about their jobs as the credit crunch tightens its grip. Figures on Wednesday showed the number of people claiming unemployment benefit rose for a third month running in April in a sign that Britain's buoyant jobs market is on the turn.

King made clear that BoE policymakers had no magic wand to restore the economy to health. "The Monetary Policy Committee is facing its most difficult challenge yet," he said. "We are travelling along a bumpy road as the economy rebalances. Monetary policy cannot, and should not try to, prevent that adjustment."

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King said further house price falls were also likely, though he added that no one could be sure what would happen in the end.

Concern over the housing market has risen sharply in the last few weeks. Prices have started falling as mortgage lenders, hit by the credit squeeze, have made it harder for people to take out new home loans.

A Reuters poll on Wednesday showed analysts on average expect a fall of 5 percent this year and another 5 percent next, but many commentators are much more pessimistic.

Briefing notes for housing minister Caroline Flint said prices could at best fall 5-10 percent this year. MPC member David Blanchflower has said he would not be surprised by a decline of more than 30 percent.

That could be political dynamite as two thirds of British households own their homes and the government has lobbied mortgage lenders to pass on the BoE's three official rate cuts to their customers in an attempt to revive the market.

Further interest rate cuts may be a long way off. "The probability of a June cut has been on life support since the CPI data yesterday, and the inflation report has now switched the machine off," said Alan Clarke, economist at BNP Paribas. "We now believe the next cut will be delivered in August, with a risk of (a move) later."

The BoE report shows inflation could hit 3.7 percent this year and still be clearly above the BoE's 2 percent target if interest rates come down by half a percentage point over the next year, as many analysts expect.

The risks were on the upside because of global energy prices and because the longer inflation was above the target, the more entrenched people's expectations of price rises become.

King said he expected to have to write to the government several times on how he plans to bring prices back under control — as required by the central bank's remit if inflation deviates from target by more than a percentage point.

April's figures already showed the CPI rate almost there, at 3.0 percent.

Economic growth was expected to slow to around 1 percent at the end of this year before picking up to around 2.3 percent in two years — still below the long-term trend rate.

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