Brown hit by economy warning

Labour's long-planned election campaign in 2005 will take place against a backdrop of falling house prices, rising interest rates and pressure to raise taxes or pare back growth in public spending, the west's leading economic thinktank said yesterday.

As it did so, the governor of the Bank of England, Mervyn King, urged Gordon Brown, ahead of tomorrow's pre-budget report, to ensure he met his self-imposed tax and spending rules.

In an assessment that is at odds with many City economists, the Paris-based Organisation for Economic Cooperation and Development said there would be three increases in borrowing costs next year, despite a puncturing of the property boom. Many in the City believe that UK rates have already peaked at 4.75%.

The OECD also said action would be needed to plug a gap in the government's finances.

Mr Brown tried to burnish his political credentials ahead of tomorrow's statement, giving a speech on Britishness after accepting an award as politician of the year from the Political Studies Association.

He has come under pressure from critics who claim that a black hole in his budget forecasts will force him to breach his self-imposed golden rule of balancing spending across the economic cycle.

The chancellor will insist tomorrow that this is not true. The state coffers, he argues, remain healthy enough to avoid higher taxes or having to rein back public spending, but the findings of the 30-nation OECD are likely to be seized upon by his opponents.

Yesterday, in an interview with the Financial Times, the Conservative shadow chancellor, Oliver Letwin, accused Mr Brown of creating "a condition where in order to keep sound public finance he has to raise taxes after the election".

At the same time, Mr King, who earlier this year expressed concern about the growing deficits in the public finances, reminded the chancellor of the need for fiscal rectitude.

"It is not an option or an extra, it is an integral part of the macroeconomic policy framework and I am sure the chancellor agrees with that," Mr King told a parliamentary committee.

A Treasury spokesman said the chancellor agreed with Mr King, adding: "We are meeting our fiscal rules across this cycle, as we will across the next, and all our spending plans, set out to 2008, are fully affordable. We will set out new fiscal forecasts on Thursday."

Although there have been signs in recent months of the economy coming off the boil, the OECD predicted that the respite from dearer borrowing costs would be temporary.

"The slowdown and continuing low inflation warrant a pause in monetary tightening, although further tightening may be needed during 2005, in particular due to increasing pressures from the labour market." It pencilled in three increases in interest rates for 2005, one in each of the first three quarters, taking them to 5.5%. The likeliest date for the election is May.

The government's hopes of generating a "feel-good factor" are likely to run into the headwind of weaker house prices, which will feed into more cautious consumer spending, the OECD said. It expects consumption growth to moderate from 3% to 1.8% next year, and the economy as a whole to grow at 2.6%, down from 3.2% this year.

It said: "The cooling of the housing market is likely to be an increasingly important factor in damping growth in private consumption", adding that "the link between the housing market and consumer spending suggests that with the level of house prices stabilising or even moderately falling, consumption growth may decelerate significantly".

But the OECD said that dearer borrowing was still necessary because other parts of the economy were strong and there were signs of inflationary pressures in the labour market. With inflation well below the government's 2% target, the OECD said the Bank had been right to leave interest rates at 4.75% since August.

"Nevertheless, even if the housing market damps growth in consumers' expenditure, other components of domestic demand have considerable momentum. Further increases [in interest rates], totalling around 0.75 percentage points, should be sufficient to bring the growth rate back to around, or eventually just below, the potential growth rate of 2.5% in 2005 and 2006."

On the public finances, the OECD predicted that the government deficit was likely to be above 3% of GDP in 2004 (more than £30bn). "In the absence of a spontaneous rise in taxes, additional action may be required to achieve a decisive and sustainable reduction."

A more pronounced drop in house prices remained a risk, although the OECD believed the chances of that "may be diminishing as the likelihood of a soft landing for the whole economy increases".