ITEM Club's quarterly winter forecast says that the CPI will peak at nearly 4% in February and cautions that the Bank of England may come under mounting pressure to raise its base rate. However, ITEM is urging the MPC to hold its nerve, predicting that inflation will drop back to the 2% target in 2012 once temporary pressures fall out of the economy.

As the government's austerity measures start to take effect, inflationary pressures will be coupled with below-trend GDP growth. The report forecasts UK GDP growth of just 2.3% this year, rising to 2.8% in 2012.

Interest rate hike could endanger the recovery
Peter Spencer, chief economic advisor to the Ernst & Young ITEM Club comments: "It's going to be a tense start to 2011. The fiscal retrenchment will keep GDP subdued, while commodity price rises and the VAT hike will push inflation close to 4% and leave the MPC agonising over whether to increase the Bank base rate.

"However it's vital that the MPC stands firm. These are temporary pressures, domestic cost inflation remains low and CPI inflation will come back to heel in 2012 once the VAT increase falls out of the figures next January. A premature rate rise would boost the pound, weakening the UK's ability to increase its exports - particularly into the emerging markets - which we have long maintained hold the key to the UK's economic recovery."

Consumers will feel the squeeze
Consumers will really feel the squeeze this year, after a bad 2010. In addition to rising commodity prices, the VAT hike, and the increase in employees' National Insurance Contributions this April, ITEM also expects wage increases to remain below inflation throughout the year.

ITEM Club warns that there is also a significant risk of further increases in unemployment, given the cuts to public spending. ITEM is forecasting that the unemployment count will increase marginally to 8.1% this summer before falling back to 6.8% by 2015.

To cap it off, there will be no respite for consumers in the ongoing trend of the drop-off in the UK housing market. ITEM expects house prices to fall by over 5% in the next 12 months, with only a gradual recovery in housing transactions in 2012.

Spencer says: "It's going to be tough for UK consumers this year, who are going to have a lot less spare cash in their pockets. Household incomes are going to be squeezed yet again. Add to this the prospect of rising unemployment, and the outlook appears decidedly bleak. However VAT and other increases will fall out of the CPI figures next spring, easing the pressure on disposable incomes, allowing households, the high street and the housing market to begin to share in the recovery in 2012."

Business investment provides a bright spot
There is however some good news. Business investment and exports look set to increase this year, providing the ‘bright spots' in the ITEM's Club's Winter Forecast.

Business spending bounced back strongly last year and ITEM expects strong growth this year as companies move from cost cutting mode into expansion mode. Large UK PLC has emerged from the recession ‘cash rich', with corporate cash surpluses amounting to nearly 8% of UK GDP.

ITEM is expecting these funds to be put to good use in 2011, as world output strengthens, with business investment set to increase by 9.4% this year and accelerating to 13.9% in 2012.

Spencer remarks, "Corporates have both the means and motivation to increase their capital spending. A weak domestic market provides the incentive to explore more opportunities overseas, particularly in the emerging markets. They will also be conscious that, excess cash on the balance sheet could potentially leave them vulnerable to takeover bids."

He adds, "Once companies are confident that the austerity measures are working, and this is reflected in the key economic indicators, there will be pressure to invest or return profits to shareholders."

UK exports picking up steam
2011 is also going to be a good year for exports. UK exports are forecast to grow in line with world trade, capitalising on the opportunities in the emerging markets and the weak pound. The UK will also benefit from export activity in Germany, which has been propelling the rest of Europe. ITEM is forecasting export growth of 7.3% in 2011 and 9% in 2012, with net trade adding 1/2% to GDP growth in each year of the forecast. But major challenges lie ahead.

Spencer explains: "2011 should see a stronger performance from UK exporters. However, the UK needs to build better trade relations with the emerging markets. Following the decade of the strong pound, the UK missed out on an opportunity to expand its exports into Asia and other rapidly growing markets, instead focusing on trading with our European cousins - which are now forecast to grow at a much slower rate. We are geared in to the wrong markets, and the investment required to refocus on the emerging economies is going to take several years."

However, Spencer believes that it is by no means an impossible task. "We've done it before back in the 1970's when we grew exports to Europe and the Middle East. Moreover, the strong growth recently seen in UK exports to emerging markets suggests that we are now seeing a similar reorientation. However it is one of the major risks to the forecast. We're relying on the UK's ability to capitalise on the export markets for our long-term economic growth", he adds.

Major question marks still remain
Spencer concludes: "We are on a rocky road to redemption. It will undoubtedly be a tough year, particularly for employment, wages, housing and the high street, while many major uncertainties also remain around the actual impact of Osborne's austerity measures. The growth in the UK economy all hinges on some major ‘ifs' and ‘buts' - the most significant of which, in the next 12 months, is going to be whether the MPC maintains the Bank base rate at 0.5%."