Fears that Britain could slip into a protracted depression intensified tonight as markets took fright at the US central bank's wary economic outlook, the Bank of England's own warnings on the UK, and a slew of gloomy data.

With businesses and households fretting over swingeing public sector spending cuts and shaky economic prospects around the world, the Bank cut its growth outlook and warned that Britain faces a long and "choppy recovery".

The move came as official figures showed a sharp rise in long-term unemployment and a smaller than expected fall in the number of people claiming jobless benefits.

The Bank's outlook intensified the debate over whether the economy is heading for a double-dip recession, or at least a period of depression. The National Institute of Economic and Social Research thinktank defines depression as a period when output is below its previous peak, and has predicted that in the UK's case this will last until 2012.

Faced with calls from trade unions to scale back its cuts or risk seeing growth peter out, David Cameron's coalition at least got some support for its austerity measures from the Bank's governor, Mervyn King, who reiterated that a fiscal squeeze now would reduce longer-term risks to the economy.

But the Bank also cited the cuts as at least part of the reason why it was more cautious on growth. Also blaming tight credit conditions and increasingly fragile confidence among consumers and companies, its quarterly inflation report, which forecasts economic prospects two years ahead, sees growth nearer 3% then, down from its previous prediction for about 3.5%.

The softer outlook and the Bank's view that inflation will finally fall back in 2012 left financial markets scrambling to reassess the outlook for interest rates. The cost of borrowing for the government on a five-year bond fell to its lowest level in almost 20 years, as traders raised their bets that interest rates will remain at their record lows for many months to come. The FTSE 100 suffered its biggest drop in six weeks.

But many economists said the Bank was still too optimistic about growth. Even the government's own fiscal watchdog is less upbeat and the market consensus is closer to 2% growth for two years from now.

"The Bank has not taken sufficient account of the likely drag on growth from fiscal tightening," said Alan Clarke, economist at BNP Paribas. "I'm increasingly convinced growth will grind to a halt at the start of next year."

GDP growth jumped to 1.1% in the second quarter as businesses enjoyed a rebound from harsh weather at the start of the year, but few see that being sustained. "We would be lucky if third-quarter growth is even half what it was in the second quarter, which was flattered by one-off factors," Clarke said.

The Bank has been quick to warn against reading too much into that second-quarter bounce. Indeed, King's comments today were less upbeat than the inflation report itself and suggested the Bank was in no rush to raise interest rates from 0.5%. "Whereas crises occur suddenly, they fade only gradually," he said. "It will take many years before bank balance sheets and fiscal positions return to anything like normal. In the meantime they will act as headwinds to the recovery."

King appeared particularly concerned about the latest business and consumer surveys, which he said had weakened "quite markedly". Last week, a key report on the services sector, which makes up the bulk of the economy, showed growth had dropped to a one-year low as companies complained about cancelled public sector contracts. Consumer confidence has also plunged back to recession levels according to Nationwide's monthly survey today, while the prospect of hundreds of thousands of public sector job losses was blamed for falling house prices in a separate survey this week.

King also flagged up risks from overseas. He echoed the government's emphasis that the UK economy needed to be rebalanced towards net exports, but at the same time warned that achieving this "is likely to mean a choppy recovery".

The Bank highlighted signs of a slowdown in the world's largest economy after US counterparts took a cautious step towards pumping extra liquidity into the financial system today. Launching an operation described as a "light" version of quantitative easing, the Federal Reserve's open market committee said recovery was likely to be "more modest in the near term" than anticipated. At the close of business tonight the Dow Jones had fallen 265.42, or 2.5%, to 10,378.83, its largest slide since it fell 268.22 on 29 June.

King also cited risks to UK growth from troubles in the eurozone, a key trading partner, where countries are grappling with their own fiscal reforms.

The Bank appeared confident that inflation will finally fall below its 2% target in two years – although it does see inflation being higher than it previously feared in 2011, thanks to the January VAT rise.

Markets took the benign inflation outlook as a sign the Bank might well restart its own programme of quantitative easing.

Economists warned that the bumpy path of recovery would continue to be felt in the labour market after mixed data on jobs today. The Office for National Statistics said the number of people claiming jobless benefits dropped by 3,800 last month, well below forecasts for a 16,500 fall. At the same time, less up-to-date figures showed employment enjoyed its biggest jump since 1989 in the three months to June, when the overall economy rebounded. But much of that was down to companies hiring part-time workers, suggesting many are too nervous about the fragile recovery to hire full-time staff.