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OBR warns 'wage spiral' could force interest rates to 3.5 PER CENT

The government's watchdog today warned that a 'wage spiral' or energy shock could drive inflation to a three-decade high of  5.4 per cent next year and force the Bank of England to take drastic action.

In a stark assessment alongside the Budget, the Office for Budget Responsibility (OBR) said its central forecast is for headline CPI to peak at 4.4 per cent in the second quarter of year.

That is far above the current 3.1 per cent, and more than double the Bank's 2 per cent target. 

But it warned that data since the document was prepared suggests that a figure of 5 per cent could be more realistic.

The watchdog put forward two scenarios where the situation could get dramatically worse - with either a 'mild wage spiral' developing or continuing pressure on energy and product prices. 

In both, CPI inflation could go up to 5.4 per cent, with the OBR saying that the Bank of England base rate would need to soar to 3.5 per cent from the low of 0.1 per cent now. 

The OBR said that in its scenarios where a 'wage spiral' developed or product prices keep rising, Bank of England governor Andrew Bailey (left) would need to raise the base rate to 3.5 per cent from the low of 0.1 per cent now

In both scenarios, CPI inflation could go up to 5.4 per cent, with the OBR saying that the Bank of England base rate would need to soar to 3.5 per cent from the low of 0.1 per cent now

n a stark assessment alongside the Budget, the Office for Budget Responsibility (OBR) said its central forecast is for headline CPI to peak at 4.4 per cent in the second quarter of year

Public sector net borrowing will be lower than had been expected in March, thanks to the improved overall economic picture

Such a shift would cause huge pain for homeowners who would face massive mortgage costs.

But there would also be 'fiscal consequences' for the government as the bill for servicing the £2.2trillion debt mountiain would rise. 

The OBR said: 'In both scenarios, a further sharp and persistent increase in costs means inflation peaks at 5.4 per cent (1 percentage point above our central forecast and the highest rate in three decades) and then falls back more slowly than in our central forecast. 

'Based on a simple monetary policy rule, Bank Rate in our scenario reaches 3.5 per cent (its highest since November 2008), thereby suppressing demand and moderating inflationary pressures, but even so it still takes a year longer for inflation to return to the target than in our central forecast. 

'At its peak, the impact of this vigorous monetary tightening prevents a further 2 to 3 percentage point rise in inflation, and without it the price level would be some 6 to 8 per cent higher at the scenario horizon.' 

The OBR's central forecast upgraded growth for this year from the 4 per cent it suggested in March to 6.5 per cent - less than some had hoped but still enough to return to pre-Covid levels of activity. 

Next year GDP is expected to be 6 per cent, lower than the 7.3 per cent at the last set of figures. 

Critically the 'scarring' - long-term damage to the economy - is now only thought to be 2 per cent rather than 3 per cent.   

The watchdog also now forecasts that unemployment will peak at 5.2 per cent, a fraction of what had been anticipated at the height of the crisis. 

'Today's Budget does not draw a line under Covid. We have challenging months ahead,' Mr Sunak said.

'But today's Budget does begin the work of preparing a new economy post-Covid.' 

Public sector debt does not rise as high under the latest OBR projections 

The tax burden is going to its highest level since the Second World War, despite Rishi Sunak's promise that he wants to cut it 

Government spending is going to continue higher than it was before the pandemic as a proportion of GDP

The scenarios with a huge spike in inflation would have knock-on effects for the wider economy, the OBR said