The Chancellor’s hopes that a swift revival in the economy by next year will limit damaging political fallout from rapidly weakening growth were dealt a series of blows last night by the International Monetary Fund (IMF).

In its latest annual economic health check on Britain, the IMF gave a warning that, despite the slowing economy, inflation dangers meant that the Bank of England had no scope for more interest-rate cuts in the near-term to underpin flagging growth. Interest rates could need to rise should any signs emerge of inflation-busting wage deals that could stoke the continued threat from price pressures.

The IMF took what will be seen as a swipe at Alistair Darling’s decision this month to hand out a £2.7 billion emergency tax cut to compensate losers from the scrapping of the 10p tax band. It told the Government that it should not waver from its plans to rein-in spending growth in the next two years in a budget-tightening that would also contribute to curbing inflation.

In a hard-hitting report, the IMF reaffirmed its stark April forecasts that the economy faces two rough years and said that Britain was more exposed to the global downturn than many of its economic rivals. The IMF expects the economy to grow this year by only 1.75 per cent, in line with the bottom end of Alistair Darling’s present forecast of 1.75 to 2.25 per cent. While the Chancellor expects growth to pick up to between 2.25 and 2.75 per cent in 2009, the fund confirmed that it expected only a “gradual” recovery during next year, with growth no stronger than this year overall.

The warning came as official figures confirmed that the economy slowed in the first quarter (Q1) to grow by only 0.4 per cent – a third slower than the 0.6 per cent of the previous two quarters. The slowdown came despite an unexpected boost from a rebound in household spending, which rose by 1.3 per cent in Q1, up from just 0.1 per cent in the previous quarter.

The rebound in consumer demand dealt another blow to hopes of more interest-rate cuts this year. However, economists said that, with consumers exposed to sliding house prices and the credit crunch, the economy remained prone to an even sharper downturn. Q1 growth was already hit by the weakest services sector activity for three years, and the biggest fall in investment spending for five years.

The IMF said that the risks that both world and UK growth could slow even more than it was forecasting were high and the dangers were worse for Britain. The risks were compounded in the UK by the housing market correction and its potential impact on bank credit and household consumption.

Britain had enjoyed exceptional economic performance for more than a decade, giving it a strong foundation to weather global shocks. Yet the economy had still been left vulnerable by growing strains. “Imbalances emerged in recent years - inflation, overheating in housing markets, low domestic savings rates, high current account deficits, and sustained drops in the international investment position,” it said.

While the Chancellor and Prime Minister are anxious over the political toll from the squeeze on living standards, the fund offered them scant comfort. It said that wage growth must stay low to curb inflation.

With the Chancellor under intense political pressure over the Government’s finances, after being forced to borrow the £2.7 billion needed to compensate losers from the scrapping of the 10p rate, the IMF left him even more boxed-in, warning him against ditching his financial rulebook.

Soaring borrowing is jeopardising the Chancellor’s rule limiting government debt to 40 per cent of national income, but the IMF said: “We advise against any softening of the ceiling.” It said that were the 40 per cent cap to be breached “plans to bring it back under the ceiling on a sustained basis should be announced promptly”.

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