Interest rates are likely to continue rising and will reach 5 per cent within the next 12 months, the Institute of Directors (IoD) claimed today.

The business organisation cautiously welcomed last week’s half percent rise in interest rates and now expects further increases before consumer spending and the house prices are sufficiently cooled.

The IoD’s claims are formed from its Summer Economic Outlook report released today, which has predicted UK GDP growth of 3.1 per cent for the rest of 2004 followed by 2.6 per cent in 2005. This, it suggests, would result in interest rates of 5 per cent by early 2005.Graeme Leach, chief economist at the IoD, said: “It was never going to be an easy task to slow the British economy, but it is proving harder than we expected.

“In the latest IoD Economic Outlook we speculate as to whether there has been a change in consumer behaviour over recent years, with homeowners now prepared to spend more on housing costs, owing to long-term growth in personal incomes.

“Does this mean the UK economy requires shock therapy? On balance we think the case for a gradualist approach to interest rate rises is still stronger, but it is now a very close call.”

The IoD’s Summer Economic Outlook indicated that further interest rate rises were needed for three reasons:

  • concern that the UK may have reached a turning point for inflation
  • strong growth in household wealth and the potential for stronger consumer spending in the future
  • public sector output – official statistics may be understating the actual volume of Government output and therefore GDP growth

The IoD also argues that consumers will respond to higher interest rates, despite the limited evidence to date, because:

  • total debt servicing costs are actually relatively high, not low
  • the relationship between house prices and consumption appears to be weaker in the latest economic cycle

“If interest rates rise to 5%, there is a 50:50 chance of a HISS (sharp slowdown in UK house prices) versus a POP (significant falls in UK house prices) outcome for the housing market in 2005,” added Leach.