Interest rates will need to rise to 5¼ per cent in the coming months if inflation is to fall back to its target by the end of next year, a respected economic think-tank says today.

In its latest forecast for the UK and world economy, the National Institute of Economic and Social Research says "inflation in the retail and consumer price indices has remained relatively strong into the third quarter of this year", boosted by higher mortgage interest payments and more costly household durable goods.

Consumer price inflation is currently 2.4 per cent but is expected by the Bank of England to spike close to 3 per cent this winter.

The NIESR agrees with current money-market thinking that two further quarter-point increases in the cost of borrowing will be necessary to tackle inflation, but does not expect prices to rise too sharply from here. "Assuming interest rates are raised to 5 per cent per annum in November and 5¼ per cent per annum early next year, we expect inflation to rise only slightly from its current level before falling back to the [Bank's] target of 2 per cent per annum by the end of next year."

However, Martin Weale, NIESR director, dismissed suggestions that the Bank should consider a 0.5 percentage point rise at its next meeting in November - a move that might send a stronger message about inflationary pressures than the now traditional quarter-point change.

"It makes very little difference if you have 25 [basis] points now and 25 points in February. A change by an amount more than people are used to . . . may lead people to conclude things are much worse than they thought," said Mr Weale.

The report also looks at the effects on the economy of immigration. Describing the recent inflow of workers from new European Union member states as "an additional shock" to the labour market, NIESR calculates that in 2004 and 2005 overall immigration contributed about 1 percentage point to total gross domestic product growth of 5.3 per cent.

Source:  Financial Times