Top thinktank calls for increase in interest rates

One of the country's top economic thinktanks has urged the Bank of England to raise interest rates 0.5% to ensure the government hits its inflation target.

Siding with the hawks in the City, who say rates have further to rise, the National Institute of Economic and Social Research said the strength of economic growth, the rise in oil prices and rapidly falling unemployment meant the risks of monetary policy being too loose outweighed the risks of it being too tight.

"In view of this, the MPC should raise rates to 6.5% by the beginning of next year and we have assumed this in our forecast," said the National Institute in its quarterly review published today.

The institute has consistently been one of the most accurate economic forecasters in recent years and its view on rates challenges the assumption priced into financial markets that rates have peaked.

Barring any major policy errors or macroeconomic shocks, the institute said the economy could look forward to at least two more years of strong growth, with output predicted to expand 3.6% next year and 3.1% in 2002.

While the tightness of the labour market meant earnings growth would increase, this would be offset by strong productivity growth of close to 3% in each year.

Backing the analysis of many City economists, the National Institute said buoyant growth ensured there would be a budget surplus of £15bn this year, £10bn more than projected by the chancellor in March.

But that did not justify any relaxation of fiscal policy, which could put further upward pressure on interest rates.

The institute said the strength of the public finances appeared to make more generous state pensions affordable. "However, a proper assessment should take into account the effects of population ageing on a pay-as-you-go pension system."