Homeowners and businesses face further rises in interest rates, the Bank of England indicated yesterday as it raised its forecasts for growth, inflation and house prices.
Mervyn King, the Governor, warned households to "think carefully" about the amount of debt they could afford to take on if borrowing costs rose.
Its new forecasts showed inflation was set to stay at or above its 2.5 per cent target for the whole of the two-year forecast horizon while the economy grew above its long-run trend rate.
Unveiling its latest economic forecasts, Mr King said: "Overall, the outlook is somewhat stronger than in August. Steady growth at home and abroad and diminishing spare capacity are likely to mean that underlying inflationary pressures will build gradually."
But the Bank played down fears of an aggressive campaign of rapid rate rises, saying it was "mindful" of the impact higher borrowing costs would have on highly indebted households.
Its forecasts were among the most upbeat it has published since it won independence on monetary policy six years ago, analysts said.
It said the outlook for consumer spending and house prices was stronger than in August, the labour market was tightening, business investment was growing and Government spending was rising rapidly.
Mr King said there was little spare capacity in the economy, adding that the output gap - the difference between actual and potential growth - was close to zero.
"We do see a period of growth above trend through the forecast period," he said. "The end of the forecast horizon is when growth starts to push up inflationary pressures."
The report showed inflation risks had risen since August's report despite last week's rate rise. The chances of inflation overshooting the target have risen to 60 per cent from 48 per cent three months ago.
But Mr King listed a host of downside risks to its forecasts, including the state of the world economy, recent revisions to official figures and the risk of a house price crash.
"House price inflation has been well above earnings growth - that is clearly not sustainable in the medium term," the report said. "The longer house price inflation continues to exceed growth in average household incomes, the greater the additional upward pressure on spending...and the greater the risk of a sharp adjustment in house prices."
Mr King said the monetary policy committee was mindful of the uncertainty over the impact a rate rise would have on household spending "resulting from the high levels to which household debt has risen".
Economists in the City, where the pound rose yesterday, were unanimous in saying last week's quarter-point rate rise to 3.75 per cent was not the last. But there was a range of views on how far rates would rise. Some thought the first rise could come next month.Reuse content