Rates rise “could derail recovery”

Economic growth is set to remain weak during the first and second quarters of this year, while stronger prospects for GDP could fail to materialise if the Bank of England increases the base rate, according to research by accountants BDO.

The Monetary Policy Committee is expected to raise the cost of borrowing sooner than previously expected, after the Consumer Prices Index jumped to 4% in January - twice the Bank’s 2 per cent target - and three members of the committee voted for a rate rise at the February meeting.

But BDO warned that a higher base rate could boost the strength of the pound, which would hit the manufacturing sector by making UK exports less competitive.

It said confidence in the manufacturing sector had risen to a seven-month high during February, with the BDO Optimism Index reaching 95.5.

But despite the rise it said medium term prospects still looked bleak, with the index failing to reach the critical 100 mark, which signals sustainable economic growth.

At the same time, the group’s Output Index fell further during February, dropping to 94.8, down from 95.5 in January.

Peter Hemington, partner at BDO, said: “Tackling inflation is clearly at the top of the MPC’s agenda, but it could be a policy error to raise interest rates as early as April or May, as this could seriously derail growth prospects.

“With growth forecasts remaining fragile for the next two quarters, attempts to tame inflation could push up the price of sterling and make exports less competitive, threatening what growth there is in sectors such as manufacturing. The MPC must hold its nerve, or risk scuppering recovery prospects.”

On a brighter note, the group’s Employment Index rose to 97.8 in February, up from 95, marking the first significant improvement in employment prospects since the summer.

But BDO warned that the weak outlook for growth during the first half of the year was likely to produce “continued slack” in the labour market.

It added that in order for the private sector to offset the impact of public sector job losses, the index would have to be above the 100 mark.

Meanwhile, research by manufacturers’ organisation EEF found that although there had been some improvement in the availability of finance for companies during the past two months, this had been outweighed by rising costs, with small firms continuing to face the biggest problems.

A balance of 32 per cent of companies said it had become more expensive to borrow money during the first two months of the year, up from 19 per centduring the final quarter of 2010.

Just over a quarter of manufacturers expect their demand for credit to increase during the next 12 months.

But the group warned that without an improvement in the cost of borrowing, credit constraints could act as a drag on growth.

Lee Hopley, chief economist at the EEF, said: “The improvement we saw in lending towards the end of last year seems to have been short-lived.

“While there appears to have been some easing in availability, for many smaller companies the question is still: ‘At what cost and under what terms and conditions?’.

“It is far from clear that, for small manufacturers in particular, we are on the path to easier access to more affordable finance. As a result there appears to remain a gap between the aspirations of Project Merlin and the reality on the ground.”