Bank gloomy on outlook

By Sumeet Desai and David Clarke

LONDON (Reuters) - The 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 expected spike in inflation even further above the central bank's 2 percent target meant that interest rates won't come down quickly, even with news on the housing market downturn getting nastier by the day.

Less than a fifth of economists polled by Reuters now expect a cut in June. Two-thirds did just two weeks ago. Most expect the central bank will wait until later this year before cutting rates, prolonging the pain for the economy.

"The Monetary Policy Committee is facing its most difficult challenge yet," said Bank Governor Mervyn King. "We are travelling along a bumpy road as the economy rebalances. Monetary policy cannot, and should not try to, prevent that adjustment."

"Inflation will return to the target and growth will eventually recover to a sustainable rate. But we will need to be patient."

That spells trouble for Prime Minister Gordon Brown. He is banking on a quick recovery to win back support for Labour after it was pushed into a humiliating third place in local elections this month by voters worried about the rising cost of living and falling house prices.

They may soon start worrying about their jobs as the credit crunch tightens its grip. The number of people claiming unemployment benefit rose for a third month running in April in a sign that the buoyant jobs market may be on the turn.

POLITICAL DYNAMITE