Raising interest rates to limit inflation could increase it by increasing wage demands to pay for higher mortgages and by encouraging companies to raise profit margins in order to offset interest costs, Nomura says.
Chris Dillow, author of the report, said: 'We will not wake up tomorrow to find we have high inflation, but the seeds have been sown.' Almost all the determinants of inflation were moving the wrong way. Wage costs, input and commodity prices and capacity utilisation rates were all rising.
Mr Dillow said companies were likely to push for increases in their profit margins because in many cases costs had risen since they last reviewed prices. The Bank of England should raise interest rates promptly. 'It is better to act too early than too late,' he added.
Rumours of interest rate rises have had an immediate impact on consumer confidence in the past few weeks, according to Infolink, the credit information company.
It said specialist home loan companies reported a 9 per cent fall in mortgage applications in the year to June, while demand for car loans and loans from finance houses faltered slightly.
Producer price figures for July released today are likely to show the impact of higher oil and commodity prices. In June, factory- gate figures showed no rise while input prices edged up 0.1 per cent. Economists expect a much bigger jump in input prices to be revealed by today's figures.
Robin Hubbard, of Paribas, also cautious on prices, said the economy had shown increasing signs of strength. 'It is becoming increasingly apparent that April's tax hikes have done little to slow the economy, which is already growing at a pace above its long run potential,' he said.
Other City economists are less pessimistic about prices. Simon Briscoe, an economist at S G Warburg, said: 'Any number of times in the past two years we have seen companies wanting to increase their prices but the increases have not stuck.'
Low earnings growth had made consumers more sensitive to prices. 'People shop around for bargains,' he said. 'Retailers and wholesalers have found that the volume of sales has dropped when they have pushed prices up.'
James Barty, an economist at Morgan Grenfell, said: 'Inflationary pressures are very light. The pressure is confined to manufacturing industry, where commodity prices are more important and there are short-term bottlenecks.'
Forecasts for inflation by the middle of next year range from 2 to 6 per cent, with the Bank of England's Inflation Report, published last week, opting for 3 per cent. Mr Dillow predicts 6 per cent inflation, well above the official 1 to 4 per cent target range. 'The average life of a policy target is two years,' he said.
The Bank's report said inflationary pressure could be starting to build up even as official measures of inflation continued to fall. But it also suggested that unexpectedly low inflation in recent months could bring down more rapidly the inflation expectations of people setting prices and wages.
City analysts expect the Bank to increase base rates in a pre- emptive attack on future inflation at some point this autumn. The expectation of an immediate increase, following a botched auction of Treasury bills 10 days ago, led to a brief panic in the money markets.
Stephen Hannah, head of research at IBJ International, said: 'An early September move is required if the Bank's credibility is not to be completely undermined.'
The Governor of the Bank of England and the Chancellor next meet to discuss monetary policy on 7 September. The minutes of their June meeting will be published on Wednesday.Reuse content