Interest rates could rise to 8% by 2012

The Policy Exchange has warned that interest rates could rise to 8% by 2012 if inflation spirals out of control.

Andrew Lilico, the think tank’s chief economist, says that the Bank of England (BoE) may be forced to dramatically increase the base rate due to rapidly rising inflation.

This is in stark contrast with Ernst & Young’s economic forecast, published last month, which suggested that the base rate will remain at the historic low of 0.5% until the end of 2013.

Lilico warns the UK is likely to suffer from a double dip recession, but he believes this will be followed by a boom leading to the strongest economic growth since the 1980s.

Lilico says: “Once the economy gets growing sustainably, there will be a huge expansion in the money supply, which will lead to inflation.”

He warns that the £200 billion the BoE has injected into the economy through quantitative easing has quadrupled the money base. He says once the economy starts growing again, lending will expand and there will be “too much money chasing too few goods”. (article continues below)

Lilico says this will trigger a rise in inflation and interest rates. He says: “Since interest rate rises will raise mortgage rates, the initial effect will be even more inflation.”

He expects inflation to rise to around 10% and he predicts that this, in conjunction with a rise in interest rates, could cause another recession in 2013 or 2014.

Lilico adds that if households do not reduce their debts between now and 2012, interest rate hikes to 8 per cent would lead to mass mortgage defaults.

He said: “If that is the case, then interest rates may have to be kept lower for an additional nine months and the consequence will be inflation peaking at 20% rather than 10%.”