The Bank of England should begin hiking interest rates in the second half of this year and lift borrowing costs to 3.5% by the end of 2011 to control rising inflation, an economic report warned today.
The Organisation for Economic Co-operation and Development (OECD) said in its latest outlook that while record low interest rates had been "appropriate" so far in the recession, the Bank must act soon to return rates to normal.
It added that even with the temporary pressures of the VAT rise and higher fuel prices taken into account, rate action needed to be taken to see off the threat of inflation.
The OECD said: "Notwithstanding the temporary nature of these price developments, the gradual drift up of some measures of inflation expectations implies a need to increase interest rates earlier than previously thought and no later than the last quarter of 2010."
It is predicting economic expansion of 2.2% in the UK this year, rising to 2.6% next year, but said growth could stall in the second half as consumers come under pressure.
Inflation has been stubbornly above-target in the UK, hitting a 17-month high of 3.7% in April.
But the Bank of England has repeatedly predicted a return to the 2% target this year and indicated it was in no hurry to increase interest rates or wind down its £200 billion money supply boost.
The OECD has changed its view on rates, having said last November the Bank should not start tightening monetary policy until 2011.
However, it acknowledged in today's report that hefty austerity measures by the new UK Government could "leave room" for more gradual rate rises.
Its forecast for UK gross domestic product (GDP) growth has also changed since last November's report, upgraded from an original prediction for expansion of just 1.2% this year.
The OECD said: "The recovery is gaining traction, supported by improving financial conditions, rebounding exports and a temporary surge in stockbuilding.
"High inflation and lingering effects from the credit crunch, together with necessary fiscal tightening, will nevertheless keep growth subdued in 2010.
"The recovery will gain momentum in 2011 when household consumption and business investment start to grow more robustly."
Official figures yesterday revealed the UK economy grew slightly faster than first estimated in the initial three months of 2010, with GDP expansion upgraded to 0.3% from 0.2%.
The OECD said UK unemployment levels would also peak in mid-2010 and ease back slowly.
However, it said action to reduce Britain's deficit must be made swiftly and urged the new Government to declare detailed measures soon.
"Return to fiscal sustainability requires further consolidation, which should be announced early and supported by a strong and credible medium-term fiscal framework," said the OECD.
It added that a "fully articulated fiscal plan would help the recovery" by easing market concerns and dampening inflation expectations.
Today's report included similar messages for governments worldwide, with calls to tighten monetary policy and speed up austerity measures.
It also recommended that the US, Canada and European Central Bank should start to increase rates this year.
The May forecast upgrades growth prospects for a raft of countries, with the US expected to see activity rise by 3.2% this year and in 2011 compared with 2.5% and 2.8% previously.
Overall, it raised 2010 and 2011 GDP forecasts for the OECD countries by 0.8% to 2.7% and 2.8% respectively.Reuse content