Tax limits could spell 1% interest rate hike

Interest rates could rise a full 1 per cent this year thanks to the Chancellor's insistence on not increasing taxes to pay for higher public spending.

That is the forecast of the Ernst & Young Item Club, the economic forecaster that uses the Treasury's model of the economy. The Item Club's record on predicting where public finances are going has been more accurate than the Treasury in recent years.

Most economists expect the Bank of England to raise rates by 0.25 per cent to 4 per cent next month as concerns about consumer spending and a still healthy housing market weigh on the Monetary Policy Committee. However, the Item Club believes it will be the effect of higher government spending, putting pressure on scant economic resources, that could bring inflationary pressure and lead to further rises in the back end of this year.

Peter Spencer, the Item Club's chief economic adviser, said wage inflation could be the big untold story of the UK economy. "Contrary to popular belief, incomes are rising quite strongly. Although average earnings are quite depressed, employment growth is quite strong. We predict a 3.4 per cent growth in real disposable income in the UK economy this year," said Professor Spencer.

He wants a brake on consumer spending so that extra government spending earmarked by the Chancellor in the last two budgets does not force up inflation.

"It really should be the Chancellor raising taxes, but as he has signalled that he is not going to do that, it will end up being the Bank of England raising interest rates," he said.

Higher rates will be at odds with events in the US and Europe. In the US, the Federal Reserve Board has indicated it is not looking to raise rates, despite strong consumer spending, higher defence expenditure and a rising budget deficit. In Europe, the dollar's weakness and the euro's strength have meant the European Central Bank may consider cutting interest rates to soften the currencies' effect on the eurozone economies.