Bank of England boss Mervyn King said grim GDP figures served as a stark reminder that Britain's recovery will be "choppy" as he braced consumers for a bleak year ahead.
In a speech in the North of England, the Bank governor warned Britons to expect inflation to rise to between 4% and 5% over the next few months.
Real wages will plunge back to 2005 levels as prices soar and the Government's deficit-busting actions take effect, he added.
While the economy was "well placed to return to sustained, balanced growth", Mr King outlined strong headwinds facing the economy in 2011.
Rising unemployment and declines in real earnings will hit spending in the private sector, with the public sector hammered by government spending cuts.
But it was inflation that was the governor's biggest immediate headache.
He told the accountants' business dinner: "GDP figures remind us that, as I said last year, the recovery will be choppy. Of more immediate concern to the Monetary Policy Committee is that we are experiencing a period of uncomfortably high inflation."
Figures from the Office For National Statistics yesterday show the UK economy shrank by 0.5% in the last three months of 2010, confounding expectations of growth of up to 0.6%.
Mr King told listeners at the Civic Centre in Newcastle: "With the standard rate of VAT rising to 20% this month, and recent further increases in world commodity and energy prices, inflation is likely to rise to between 4% and 5% over the next few months, before falling back next year."
His move to increase Bank inflation expectations yet again will heap further pressure on the MPC.
There have been calls for action after inflation rose to 3.7% in December, far higher than the Bank's 2% target. Fellow MPC member Andrew Sentance - who has repeatedly voted for a quarter point rate rise to ease inflation - said in a speech this week the "time has come to act" as he cautioned price pressures were not one-off.
The GDP figures will have taken some of the heat off the Bank to increase rates, but they also highlight the difficult situation faced by policymakers.