The Bank of England has focused too much on avoiding deflation at the expense of countering declining real incomes, according to Cazenove.
Richard Jeffrey, Cazenove's chief economist, says Britain stands "on the cusp of a very nasty problem" where rises in real take home pay severely lags price inflation.
While inflation hit 3.1% in July, the latest quarterly measure of average weekly earnings growth fell to around 1.5%, from almost 5% in late 2008.
The impact of the VAT increase in January will exacerbate the difference, Jeffrey adds.
He says the coalition Government has "driven down a blind alley" in its bid to stave off price deflation by printing more money and keeping interest rates at 0.5% since March 2009. "The scope for manoeuvre is limited," he adds.
Instead of stimulating demand, quantitative easing has created inflation in financial asset prices, Jeffrey says. "It is not clear that further QE will have the desired effect, since it is more likely to create a pool of liquidity in the financial sector than raise real demand."
Meanwhile, low interest rates could actually encourage households to save, not spend, especially if investors have to put away yet more cash to earn greater income on their investments, he adds.
This, together with the present squeeze on income growth, could lead companies to become more price-competitive, fuelling deflation.
"For companies more focused on the domestic economy for their earnings, this is very much a Catch-22 situation, and is almost certainly bad news, at least in the short term," Jeffrey says.
"Those companies that focus on maintaining volumes rather than prices are more likely to win out in the medium to long term.
"The better news for the UK stock market is that a comparatively low proportion of profits are generated domestically."
