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Interest rates 'may hit 8pc' in two years

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Andrew Lilico, chief economist at the influential Policy Exchange think tank, has warned of an interest rate environment not seen since the 1990s. He said the rise could happen as the recovery beds in and Government measures to stave off a recession lead to an explosion in the money supply. Mr Lilico also warned of a return to "boom and bust", as ballooning inflation threatens to tip the economy back in to recession in 2013 or 2014.

"Given the constraints of late 2008 and the absurdities of subsequent fiscal, finance and regulatory policy, if we can get away with a recession of only 6.6pc, deflation of only 2pc and inflation of only 10pc for one year, [Bank of England Governor] Mervyn King will deserve a medal," Mr Lilico said. A brief double dip recession early next year is likely, he said, but it "would be quite compatible with a boom thereafter". That boom would quickly run out of control, as the £200bn of "money printing" by the Bank during the crisis would lead to "a huge expansion in the money supply, which will lead to inflation". He estimates that the Retail Prices Index (RPI), the inflation measure favoured in wage settlements and against which annual rises in train fares are priced, would rise "above 10pc".

The Consumer Prices Index (CPI), the inflation measure that the Bank is responsible for keeping at around 2pc, will top 6pc, Mr Lilico reckons. "I believe that this will be the combined result of natural recovery-driven growth and massive and unsustainable investment driven by huge monetary growth," he said.

This week, official data from the Office for National Statistics is expected to confirm that the economy grew 1.1pc in the second quarter of the year – reinforcing hopes that the recovery is strong enough to withstand the Coalition's planned spending cuts. To control inflation, "interest rates will rise rapidly as well", Mr Lilico says. "To keep [RPI] inflation down to only 10pc for one year, the economy will have to be able to tolerate interest rates of perhaps 8pc."

Mr Lilico's alarmist comments echo those of Sir John Gieve, the former Bank of England deputy Governor, who said last month that he expects "rates to start rising faster than the market currently expects … I wouldn't be at all surprised to see interest rates at 2.5pc a year from now". High interest rates, however, could prove too much for households, which are currently benefiting from historically low average mortgage rates of 4pc. Mr Lilico added: "There is a risk that... the economy will not be able to tolerate 8pc interest rates without the mass defaulting on mortgages that we are trying to avoid. 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 20pc rather than 10pc, as in the 1970s.

The consequence of interest rate rises will be another recession in 2013 or 2014," he said.

Mr Lilico, a monetarist at the right-of-centre think tank, is close to the Coalition but his ideas are considered extreme. He said: "The fact that scenarios such as mine are regarded as bizarrely unlikely is, to my mind, an indication that certain quarters have lost their sense of historical perspective... "Policymakers in the early 1990s did not want inflation to exceed 10pc – they simply lost control of the situation and were unable to prevent it. Are we really so confident that there is no chance of policymakers today losing control of events?"




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