The National Institute of Economic and Social Research (NIESR) has warned that interest rates may need to rise as high as 5% to bring inflation under control, while the Government is compounding economic pressures by delaying difficult decisions on tax and spending.
The think tank said choices around both monetary and fiscal policy were being "deferred", cautioning that this risks exacerbating inflation across the UK economy and placing further strain on the public finances.
Inflation Forecast and Bank Action
Fresh forecasts from NIESR show Consumer Prices Index (CPI) inflation in the UK reaching a peak of around 4.4% in February, up from the 3.8% peak forecast in July.
Surging inflation prompted the Bank of England to act by lifting interest rates to 4% last week, the first increase in more than three years. NIESR said it anticipated the Bank would raise rates once more, but that this would prove insufficient, meaning inflation would not return to the 2% target until late 2030.
This would hit less affluent households the hardest because it leaves them with little option but to buy less, rather than adjust their spending patterns or draw on savings, it said.
Fiscal Policy Concerns
Rates need to reach as high as 5% to address the threat of second-round inflation effects, which will emerge early next year when firms set their wages and prices, according to its analysis. The Bank is only inviting future increases by postponing action now, it argued.
Meanwhile, NIESR also criticised the Government's fiscal policy, contending that significant spending commitments remain without proper funding, including those for defence, social care and disability.
In last month's autumn Budget, Chancellor John Healey confirmed that the UK's fiscal headroom will shrink to £14.5 billion from £23.6 billion, a reduction attributed to a surge in debt interest costs over the past year.
Fiscal Rules and GDP Outlook
NIESR said plans to balance the public finances depend heavily on constraining public spending earmarked for the coming years. However, its analysis found that if the plan falls short by as much as previous ones have done, then the Government's fiscal rules would be breached by approximately £30 billion.
The think tank contended that the Chancellor failed to seize the opportunity at the autumn Budget to place the public finances on a more solid foundation, and challenging decisions about taxation and spending were largely deferred.
During the summer, NIESR urged the Government to increase or reform taxes or implement spending reductions in order to fund fresh cost-of-living and defence commitments.
Elsewhere in the latest report, it forecast UK gross domestic product (GDP) at 1.6% this year, stronger than an earlier prediction of 1.4%, driven by Government spending and business investment, including in AI. However, GDP is forecast to slow to 1.1% next year, lower than the previous projection of 1.3%.
