Forecasters see inflation `nightmare' if rates do not rise

The British economy faces the danger of a "nightmare scenario" of slower growth and rising inflation unless the Bank of England goes ahead with an increase in interest rates within the next two months, according to a new forecast.

The Ernst & Young Item Club, which uses the Treasury's own model for its forecasts, says that if the Bank does not engineer a soft landing for the economy with one more tightening of the ratchet now, it will have to raise rates to 8 per cent by the summer. This alarming warning is based on the prospect that consumer spending will not slow rapidly enough while the pound squeezes exports by staying stubbornly high.

John Gaster, chief economist of the Item Club, said: "Everything hangs on the consumer and the pound - if both stay strong for much longer, we shall be in for a bumpy ride."

Mr Gaster thinks the Bank of England will bite the bullet in February or March. In that case, he forecasts a reasonably gentle slowdown to 2.2 per cent growth this year and 1.9 per cent in 1999. Underlying inflation would stay around 2.8 per cent.

But in the nightmare alternative, slightly higher growth this year would be followed by a sharp dive to 1.5 per cent growth next year, and underlying inflation would climb to 3.6 per cent, outside the Government's target range.

The Item Club's view about where the risks lie, however, differs from many other economists. Others expect the impact of the Asian crisis to cool the British economy rapidly without the need for higher rates.