Worst inflation since early 1990s prompts rate rise fears

The prospect of further interest rate rises loomed larger yesterday after the government revealed that consumer-driven growth was prompting a sharp pick-up in the cost of living.

Official figures showed the heftiest rise for 15 years in the GDP deflator - a measure of underlying inflation - heightening fears at the Bank of England that price pressures are building up in the economy.

City analysts said the combination of stronger growth and higher inflation made it more likely that the Bank's monetary policy committee would raise rates by a quarter point to 5.25% later this year, with November the likeliest date.

Publishing its breakdown of growth in the second quarter of 2006, the Office for National Statistics said the economy expanded by 0.8% in the three months to June and had grown by 2.6% since the spring of 2005. New figures showed consumer spending rallied from its dip earlier this year to a 1% quarterly rise.

Inflation, as measured by the GDP deflator, rose from 2.4% to 3.4% between the first and second quarters, and was at its highest level for three years. The 1.5% jump in the second quarter alone was the strongest since the early 1990s.

Michael Saunders, an economist with Citigroup, said the ONS data "altered the balance of the interest-rate debate". Unless there was clear evidence of the economy weakening, or of tougher financial conditions, the MPC was likely to "hike again in November".

Separate figures from Britain's banks suggested demand for mortgages cooled in July, even before the MPC pushed up interest rates to 4.75% in early August. However, James Knightley, an economist at ING Bank, said it was possible that annual economic growth would strengthen to 3% in the third quarter - increasing the chances of a November rise.

He said: "The outlook thereafter is less positive, with rising borrowing costs, utility bills and unemployment set to lead to weaker consumer activity, while the growing threat of a significant US slowdown and sterling strength will also weigh on activity."