LONDON (Reuters) - The British economy could shrink for a quarter or two and inflation may near four percent this year, the Bank of England said yesterday 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 two 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 of England 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 evenutually 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 his Labour Party 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 Britain's buoyant jobs market may be on the turn.

King said further house price falls were also likely, adding to sharply rising concerns over the housing market 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.

Another Reuters poll yesterday showed analysts expect a five-percent house price fall this year and another five percent in 2009, but many commentators are even more pessimistic.

Bank of England policymaker David Blanchflower has said he would not be surprised by a decline of more than 30 percent.

That could be political dynamite in a country where two thirds own their homes. The government has been lobbying mortgage lenders to pass on the BoE's three official rate cuts to their customers in an attempt to revive the market.

But 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.

The BoE report shows inflation could hit 3.7 percent this year and still be clearly above its two percent target if interest rates come down by half a percentage point over the next year.