Brown's spree will force up interest rates, says Niesr

Interest rates will need to rise by half a percentage point to quell the inflationary impact of Gordon Brown's bumper increase for public spending, a leading independent economic thinktank warned yesterday.

Experts at the National Institute of Economic and Social Research said the chancellor's 6.7% real terms increase in public spending this year was "awkwardly timed" because the economy was already running at close to full speed.

"Inflationary pressures will build up because the economy will be growing faster than its potential trend rate of growth at a time when there is little spare capacity," the institute said in its quarterly report on the economy.

The Niesr experts predict that the Bank of England's monetary policy committee will be forced to increase the cost of borrowing by 0.25% by the end of the summer, to 6.25% and to 6.5% by the beginning of next year to damp down inflationary pressures.

US interest rates also look set to rise after new figures showed that employment costs and orders to factories for high-pric ed durable goods surged in June.

Manufacturing orders rose by 10%, led by a record increase in demand for aircraft, the largest monthly increase in nine years. The market had been expecting a rise of just 0.1%. Meanwhile, wage and benefits costs rose by 4.4% over the 12 months to June, also a nine-year high.

Analysts said the figures called into question the widely held view that the economy was beginning to slow. "Today's numbers keep the Fed very much in the picture," said Anthony Karydakis, senior economist at Banc One Capital Markets in Chicago.

Despite the threat of higher interest rates, the Niesr report said the British economy was set for a period of relatively high growth, with output expected to rise by over 3% this year and next.

Stronger productivity growth would allow earnings to rise as well, the institute noted, although it warned that if the productivity improvements did not materialise, borrowing costs would need to be higher still.

Niesr's economists believe that Britain could enter the single currency with the pound valued at around €1.55 - equivalent to DM3, well above most previous estimates of the sustainable rate.