Britain will be forced to raise its interest rates much sooner than expected and certainly before the end of the year, the world's leading economic think-tank said yesterday.
The Organisation for Economic Co-operation and Development (OECD) said that with inflation still well above the Bank of England's 2 per cent target – and continuing to surprise on the upside – higher rates were inevitable.
"The authorities face the challenge of preserving credibility," the Paris-based think-tank warned in its biannual Economic Outlook yesterday.
"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."
Rates will need to be as high as 3.5 per cent by the end of 2011, the OECD added, seven times the current 0.5 per cent at which the Bank of England has maintained its base rate since March of last year.
The OECD's warning is the starkest suggestion yet that inflation, which hit 3.7 per cent in April, may not come back within the Bank's target range as quickly as the Monetary Policy Committee has suggested.
In last week's Inflation Report, the Bank itself conceded that the risk of ongoing high inflation had increased in recent months, but Mervyn King, the Governor, said he still expected price rises to fall back to 2 per cent with a year. The Bank also appeared to be expecting more modest rate increases in the short and medium term than the OECD is calling for.
Higher rates could lead to a big rise in the number of homeowners defaulting on mortgage repayments, as well as acting as a brake on the pace at which Britain's economy recovers.
In fact, the OECD is more optimistic than many economists about the prospects for the UK, forecasting growth of 2.2 per cent this year and 2.6 per cent in 2011. But it warned that in addition to the monetary tightening it advocates, "further fiscal consolidation [is] essential".
That will be seen as tacit backing for the spending reductions that the Government has begun to push through, with £6.2bn of cuts for this financial year announced by the Chancellor this week and further reductions for future years expected in next month's emergency Budget.
Moreover, despite the inflation warning for the UK, the OECD's report prompted a recovery on world stock markets, with the think-tank unveiling a substantial upwards revisions of its global economic growth forecasts. The OECD said it now expected the world's economy to grow by 4.6 per cent this year and by 4.5 per cent in 2011, compared to the predictions of 3.4 per cent and 3.7 per cent it made six months ago.
That helped markets to recover some of the dramatic falls seen on Tuesday. The FTSE 100 index rose by almost 2 per cent to 5,038, back above the psychologically important level of 5,000. Bourses across Europe registered similar gains, while the Dow Jones was up by almost 1 per cent in early trading.
Nevertheless, the OECD warned that very serious risks to the recovery remained, both from the sovereign debt crisis in the eurozone and from the possibility of overheating in markets such as India and China.
"The is a critical time for the world economy: co-ordinated international efforts prevented the recession from becoming more severe but we continue to face huge challenges," said Angel Gurria, the OECD's secretary general. "Many OECD countries need to reconcile support to a still fragile recovery with the move to a more sustainable fiscal path."
The OECD said that unusually low interest rate regimes should only be continued in the eurozone and Japan, and called for rate rises similar to those it wants for the UK in both the US and Canada.