Interest rates will have to stay low until end of 2013, say economists

INTEREST rates should be kept low for several years to help the UK's economic recovery, according to an influential report.

The Ernst & Young Item Club predicts that the coalition Government's fiscal tightening will slow economic growth over the next two years.

However, the Item Club believes that Chancellor George Osborne's plan to cut the

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deficit will lead to more sustainable high-quality growth from 2013.

Professor Peter Spencer, of the University of York, who is chief economic adviser to the Ernst & Young Item Club, said: "The new coalition's plans to cut the deficit are certainly ambitious.

"But the bulk of the additional tightening is set to come in the second half of the parliamentary term, when we believe that the recovery will be firmly entrenched and the economy should be able to deal with the headwinds from the Budget."

Mr Spencer added: "On the assumption that the Government is able to implement the overall reduction of 40bn set out in the Budget, we expect that UK growth will struggle to reach one per cent this year but will gradually speed up in the following years to give the UK a high-quality recovery based on trade and investment."

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Fiscal corrections focused on spending cuts are more likely to lead to debt reduction, with limited impact on growth, according to the Item Club.

However, with the deficit being so large the Government "had no choice" but to raise taxes, the report states.

Mr Spencer said that the VAT rise will help to plug the fiscal black hole over the following 12 months.

But after that, any forecast for the UK economy is fraught with uncertainty, he warned.

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"The medium-term outlook for growth, inflation and interest rates is critically dependent upon the coalition's ability to cut back spending," he said.

The report says that high energy prices and the increases in VAT will keep CPI inflation above target over the next 18 months.

However, Item believes that it will then move well below two per cent as these factors wear off and spare capacity affects pricing decisions and wage bargaining.

To prevent CPI inflation moving below one per cent, it will be necessary to keep the Bank base rate low at 0.5 per cent for much longer than the marketshave anticipated, the report argues.

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The Item forecast suggests that the base rate will remain on hold until the end of 2013, although this is based on the assumption that the impending spending cuts will be made.

"A base rate of 0.5 per cent will begin to look like the new normal," Mr Spencer said.