Soaring price of oil could result in sharp rate rises, warns think-tank

The Bank of England will be forced to raise interest rates sharply in the face of a slowing economy if soaring oil prices start to drive up consumers' inflation expectations, an independent think-tank warns today.

The National Institute of Economic and Social Research raised its forecasts for inflation but cut its forecast for economic growth for this year and over the medium term. It reiterated its warning that the Government would have to order a £10bn tax rise - equivalent to 3p on the basic rate of income tax - to avoid breaking its "golden rule" on the public finances.

In its quarterly report, the institute said there was "little scope" for further rate cuts despite "unexpectedly weak" economic growth. It said: "The Bank must be concerned about the risk that inflation expectations start to drift if inflation moves further above target. If this were to occur it would be far more difficult for the Bank to control inflation without stronger movements in interest rates."

The institute said if workers responded to the doubling of oil prices with higher wage demands, the Bank would have to raise rates above 5 per cent for the first time in five years.

Asked whether he thought the Bank should act now, Martin Weale, the institute's director, said: "Our forecasts do imply an upward move is more likely than a downward move."

The institute cut its forecast for GDP growth this year to just 1.7 per cent, down from its April forecast of 2.7 per cent and well below the Treasury's latest guidance of 2 to 2.5 per cent. It said the risks were that growth would fall further if increases in interest rates triggered a crash in the UK's "unsustainable" housing market.

It cut its estimate of trend growth for the economy to 2.4 from 2.5 per cent and further from the Treasury's estimate of 2.75 per cent. The shadow Chancellor, George Osborne, said the report "is a considered and powerful critique of Brown economics".