Bank ‘must keep nerve on rates’

Some economists fear that price rises caused by the VAT increase will fuel inflation

The Bank of England should “hold its nerve” and avoid pressure to raise interest rates, an influential economics forecaster has said.

The Ernst & Young ITEM Club says any increase in the bank base rate from the current historic low of 0.5% could endanger the economic recovery.

The bank should stand firm against temporary pressures such as the VAT rise, it says.

Meanwhile, Deloitte is warning of a “bumpy road to recovery”.

In its 2011 UK economic review, it says it expects GDP growth this year and next of just 1.5%.

Meanwhile the more-optimistic ITEM Club forecasts UK GDP growth of 2.3% this year, rising to 2.8% in 2012.

Deloitte believes the UK economy is building up momentum but that “the true test” – the severe fiscal squeeze – is yet to come.

And it warns that fiscal tightening could leave the recovery looking lacklustre over the next couple of years.

Deloitte also says current rates of inflation – with the CPI rate at 3.3% and RPI rate at 4.7% – will add further pressure to household incomes.

The accountancy and consulting firm says despite these high rates, its expects inflation to fall by about 1.5% next year, to about 1.8%.

The ITEM Club is also predicting inflation will drop back to the 2% target in 2012.

It says that as the government’s austerity measures start to take effect, inflationary pressures will be coupled with below-trend GDP growth.

“It’s going to be a tense start to 2011,” says Peter Spencer, chief economic adviser to the Ernst & Young ITEM Club.

“The fiscal retrenchment will keep GDP subdued, while commodity price rises and the VAT hike will push inflation close to 4% 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.”

Deloitte says that although government cuts are spread over many years, it points to public sector employment already falling, the recent VAT increase, and the national insurance contributions hike in April.

The report says that the only alternative to the government’s current strategy appears to be if the Bank of England’s monetary policy committee conducts more quantitative easing and pumps money into the economy.

Deloitte also points out that pressure is on the private sector to keep the recovery going, but that questions remain over whether it can generate enough jobs to offset the public sector job cuts.

“The onus is therefore firmly on those parts of the economy which are relatively immune from the direct effects of the fiscal squeeze – namely exports and investment – to drive growth instead,” says Deloitte economic adviser Roger Bootle.

“At least exports have been rising strongly. What’s more, the recently announced plans for an extra fiscal stimulus in the US should leave the outlook for global demand a bit brighter.”

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