Raising interest rates to tackle higher inflation would damage economic recovery

As a result, some economists are calling for an immediate increase in UK interest rates, and for rates to be 1.5, or even 2 per cent, in a year's time.

ippr does not agree, arguing that increased interest rates would be damaging at a time when the UK economy is only just emerging from recession and tax increases and public spending cuts will hold back demand in 2011.

Higher interest rates are also inappropriate because inflation pressures in the UK are largely external in their nature - higher oil and food prices are the result of strong demand in emerging economies - or are the result of tax increases, particularly the increase in VAT from 17.5 to 20 per cent. Domestic inflation pressures are very low.

Tony Dolphin, ippr Senior Economist, said:

'Talk of a wage-price spiral in the UK or a sterling crisis if interest rates are not increased in response to higher inflation is at odds with the latest evidence.

'High unemployment is holding down wage inflation in the private sector and the government is imposing wage freezes across large parts of the public sector. Meanwhile, sterling is under little threat, particularly while the Federal Reserve and the European Central Bank continue to hold US and European interest rates at their present levels. Indeed, an early increase in interest rates in the UK, because it would be unexpected, could lead to an appreciation of sterling.

'There are a number of barriers to growth in the UK over the next year or two: tax increases and public spending cuts, households reducing their debt and pressures on banks that will limit lending. As a result, growth will be slow and there will be plenty of slack in the economy. In these circumstances, domestic inflation pressures are likely to remain muted.

'An increase in interest rates now would add higher mortgages payments to the other pressures facing households in 2011: a higher rate of VAT, an increase in national insurance contributions for many, cuts in public spending and wage increases running well behind price inflation. These pressures will weigh on the growth of consumer spending, leaving the economy dependent on exports and investment spending for growth. Add in the effect of higher mortgage rates - and perhaps an increase in sterling's value - and exports and investment spending may not be able to bear the strain.'

Notes to editors

1. Consumer price inflation was 3.3 per cent in November. It was 3.0 per cent or higher in every one of the first 11 months of 2010. It has been above 2 per cent in 43 of the last 60 months, and 3 per cent or above in 24 of those months.
2. The Monetary Policy Committee left interest rates at 0.5 per cent following its January meeting, Rates have been at this level - a record low - since March 2009.

Contact

Tim Finch, Director of Communications: 020 7470 6110 / 07595 920 899 / t.finch@ippr.org