Higher interest rates 'could threaten economic recovery'

The Ernst & Young Independent Treasury Economic Model (Item) Club said any increase in Bank of England base rate would be premature and could endanger economic recovery.

Item estimates the consumer price index (CPI) of inflation will peak at nearly four per cent in February, which could put the Bank of England under mounting pressure to raise its base rate.

But the group urged the MPC to "hold its nerve", predicting inflation will drop back to the two per cent target in 2012 once temporary pressures fall out of the economy.

Professor Peter Spencer of the University of York, chief economic adviser to the Item Club, said: "It's going to be a tense start to 2011.

"The fiscal retrenchment will keep GDP subdued, while commodity price rises and the VAT hike will push inflation close to four per cent and leave the MPC agonising over whether to increase the Bank base rate.

"However it's vital that the MPC stands firm. These are temporary pressures, domestic cost inflation remains low and CPI inflation will come back to heel in 2012 once the VAT increase falls out of the figures next January."

Prof Spencer added: "A premature rate rise would boost the pound, weakening the UK's ability to increase its exports – particularly into the emerging markets – which we have long maintained hold the key to the UK's economic recovery."

Item forecasts UK GDP growth of just 2.3 per cent this year, rising to 2.8 per cent in 2012.

It predicts consumers will feel the squeeze this year, after a bad 2010. In addition to rising commodity prices, the VAT rise to 20 per cent, and the increase in employees' National Insurance Contributions this April, Item also expects wage increases to remain below inflation throughout the year.

Item also warned of significant risk of rising unemployment, owing to public spending cuts. It expects the unemployment count to increase marginally to 8.1 per cent this summer before falling back to 6.8 per cent by 2015.

It also expects house prices to fall by over five per cent in the next 12 months, with only a gradual recovery in housing transactions in 2012.

Prof Spencer said: "It's going to be tough for UK consumers this year, who are going to have a lot less spare cash in their pockets. Household incomes are going to be squeezed yet again. Add to this the prospect of rising unemployment, and the outlook appears decidedly bleak.

"However, VAT and other increases will fall out of the CPI figures next spring, easing the pressure on disposable incomes, allowing households, the high street and the housing market to begin to share in the recovery in 2012."