Stagflation is the nightmare scenario where high or rising inflation is combined with low or falling output. And last week's shock interest rate rise could have brought it one step closer, economists say. The phenomenon, which haunted Britain in the 1970s as rocketing oil prices fuelled inflation in recession-ridden economies, first returned to the lexicon last month when the Bank of England's monetary policy committee member Willem Buiter told parliament's treasury select committee stagflation was "certainly a risk", although not likely.

Tentative signs are already there. Manufacturing output is teetering on the edge of recession, in April showing the first year-on-year decline for nearly two years, and GDP growth has showed sharply, from a quarterly 0.9 per cent last summer, to 0.5 per cent now. Moreover, headline inflation hit asix-year high of four per cent in April although, admittedly, much of that was due to one-off duty increases in finance minister Gordon Brown's March budget.

Those effects will wear off eventually but last week's interest rate rise has already forced Abbey National Plc to raise its home loan rates and, with others sure to follow, that will feed into the inflation index. Just as importantly, with average earnings soaring by 4.9 per cent in the year to February, there are obvious inflationary pressures in the system. "By allowing the labour market to go on tightening in recent months, the downturn in economic activity may need to be quite severe to turn wage inflation around," said David Walton, UK economist at Goldman Sachs. "The UK economy is facing a period of stagflation in which both growth and inflation disappoint."

The problem for the Bank is that headline inflation is the benchmark against which most pay deals are set. So higher inflation could feed higher wages and vice versa, taking Britain backto another 1970s horror -- the wage/price spiral.

In other words, a nasty cycle could develop with higher rates pushing up the RPI, which in turn prompts higher wage claims, which then demand still higher interest rates. And all the while, British industry will be crushed under the weight of tighter policy.

Philip Shaw, chief economist at Investec, said there was no chance stagflation in the 1970s sense, no prospect of the 25 per cent inflation rates of 20 years ago. "The return to true stagflation is not on the cards anymore," he said. "But we could see underlying inflation loitering above the government's target with economic growth well below two per cent. That's not stagflation but it is not good news." The Bank of England's monetary policy committee stunned the financial markets last week by raising the key repo rate to 7.5 per cent. Buiter, despite acknowledging the possibility of stagflation, has consistently called for a rate rise this year, and finally got his way.

The Bank said the rate risewas due to the threat of wage inflation, a sharp fall by the pound, and its calculation that domestic demand is not slowing fast enough for the government's 2.5 per cent inflation target to be met.

If those factors do not turn around it is difficult to rule out further rate rises even though the economy, taken as a whole, is clearly slowing.

"There is certainly a danger (that) retail price and wage inflation remain too stubborn for the authorities likening," Shaw said. "There is a risk we suffer a period of below-trend growth as they raise rates to meet the inflation target."

But Michael Saunders, UK economist at Salomon Smith Barney, was confident the Bank would act quickly if growth slowed sharply.

He said the last rate cut that really took markets aback, when Brown's predecessor -- Kenneth Clarke -- loosened policy in June 1996, was reversed before the end of that year.

"If, as seems likely... earnings growth falls back and activity data stay soft, then last week's rate hike will be seen asunnecessary insurance and reversed before the year end." But Douglas McWilliams, chief executive at the Centre for Economics and Business Research, said rate cuts are some way off yet and forecast a sort of watered down stagflation. "The critical issue... is whether the economy will slow enough to reduce the upward pressure on wages. Our calculations suggest that this will not be so and that inflation will remain uncomfortably high in 1999, keeping interest rates up," he said.

"Our forecasts therefore point to extremely sluggish growth in 1999 although we expect a recovery on the back of falling rates in 2000 and 2001."