Firms are looking forward to a prosperous few months as the economy is set to stay strong in early 2005, according to a new report.

However, the report, by business advisers BDO Stoy Hayward, also warns that rising inflation and the risk of further interest rates are on the horizon.

BDO’s optimism index, which indicates growth two quarters ahead, increased in January by 0.2 per cent.

The rise could be due to a pick up in consumer spending as well as a marked increase in merger and acquisition activity, BDO said.

Figures also released today by the Institute of Directors (IOD), indicated a similar increase in business optimism.

The IOD, revealed that the balance of companies more, rather than less, optimistic about their company’s prospects, rose to 37 per cent in recent months.

With reports that the Monetary Policy Committee (MPC) are to freeze base rates at 4.75 per cent in the near future, firms will have ever more reasons to be cheerful.

However, uncertainties associated with the general election are certain to dent such optimism, BDO claim.

BDO’s figures show that output is already being held back by the effects of the sterling’s strength against the dollar, high oil prices and an increase in inflation.

Peter Hemington, partner at BDO Stoy Hayward, said: “The UK economy is looking strong going into the general election, but businesses need to prepare themselves for a jolt ahead as the Bank of England reacts to growth and inflationary pressures.

“Growth will probably slow by the end of 2005 and it is likely that we will see higher interest rates or a sharp drop in demand for products and services.”

Any kind of drop in consumer demand, along with the possibility of interest rate hikes, is likely to scare retailers, many of which are being forced to extend their sales periods well into February in order to make up for a poor sales over Christmas.

Douglas McWilliamS, chief executive of the center for economics and business research, said: “The latest ‘poll of polls’ demonstrates a real upturn in the economy, but this upbeat mood is likely to result in a post election increase in interest rates.”