Rates 'will have to rise to 8.5%'

Interest rates will have to rise to 8.5 per cent by the beginning of next year if the Government is to meet its inflation target, warns the National Institute for Economic and Social Research in its latest review.

If interest rates are held at their current rate of 6.75 per cent, inflation would continue to rise, probably exceeding 4 per cent next year, well outside the Government's ultimate target for inflation of 1-2.5 per cent by the end of this parliament.

The Institute criticises the decision by Kenneth Clarke, the Chancellor, not to raise interest rates on 5 May, saying that it could jeopardise the Government's ability to achieve its goal of low inflation. "The credibility of the authority's commitment to the inflation target received a setback."

The blow to credibility matters, the review argues, because it makes it more costly to achieve the objective of lower inflation. If the Government's commitment to its inflation target were believed, interest rates would fall to reflect lower expected inflation. The exchange rate would also appreciate.

Instead, however, interest rates would have to be raised and kept above world rates. The fall in the pound this year, the Institute says, may reflect doubts about the conduct of monetary policy in the UK.

The review forecasts that the economy will grow at 3.5 per cent this year, slowing down to 2.6 per cent in 1996. Trade will contribute about 1 per cent to the growth in GDP in each year, with exports continuing to increased sharply on the back of the competitive pound. Manufacturing will continue to be favoured with growth above 4 per cent in each year.

By contrast, the growth in consumer spending will be sluggish at 2.5 per cent in 1995 and 2 per cent in 1996. Consumption will be held back by the burden of rising taxes and a reluctance to dip into savings while debt remains high and the housing market is so fragile.

"The weakness of the housing market is perhaps the main reason why the recovery is, and will remain, rather hesitant and patchy."

The Institute points to substantial inflationary pressure from the rise in the cost of imports. However, this is being held at bay by the weakness in labour costs. This may continue because there is more slack in the labour market than the fall in unemployment might indicate.

A good part of the reduction in the number of jobless, the Institute suggests, has been caused by a crackdown on benefits. Even so, it is forecasting an acceleration in earnings growth from its current rate of 3.5 per cent to nearly 5 per cent next year.