VAT rise likely to fuel inflation

The decision to raise the standard rate of VAT from 17.5 per cent to 20 per cent next year will be a significant driver behind a stubborn rate of inflation, the Bank of England has said.

In its latest quarterly inflation report, the Bank predicted that the cost of living will remain on the high side of previous forecasts and that the VAT hike will play a major part in keeping prices up.

In June, the consumer prices index stood at 3.2 per cent, well above the Treasury target of 2 per cent.

The retail prices index, which takes account of mortgage costs, was higher still at 5 per cent.

Elsewhere in the report, the Bank forecast that the economy will grow by between 2.5 per cent and 3 per cent in 2011, down from former estimates of 3.5 per cent.

Despite the downward revision, the Bank's predictions still outstrip those of the Office of Budget Responsibility which suggest a growth rate of 2.3 per cent.

Mervyn King, the Governor of the Bank of England, explained that a decline in lending to businesses would dampen the rate at which the economy would expand and suggested that the restrictions would endure for years rather than months.

Mr King said: "It will take many years before bank balance sheets and fiscal positions return to anything like normal. In the meantime they will act as headwinds to the recovery."

Prospects for rebalancing the economy "away from private and public consumption and towards net exports", a policy on which the government is resting its hopes, would also be difficult, the Bank warned, despite the assistance offered by continuing stimulus measures and the weakness of sterling.