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The OECD also said the sluggishness of the UK economy will feed through into higher unemployment The west’s leading economic thinktank warned the Bank of England on Wednesday that it would have to start raising interest rates this year to prevent inflation taking hold in the UK. In a downbeat assessment of the prospects for the economy, the Paris-based OECD said Threadneedle Street would have to steadily increase borrowing costs over the next 18 months despite the weakness of growth. The OECD reiterated its support for the government’s deficit-cutting strategy, but said George Osborne should remove exemptions on VAT in order to boost public spending on Britain’s infrastructure. And it said a full-break up of Britain’s banks should remain an option even though the Independent Commission on Banking set up by the coalition has so far backed only more limited reform of the financial system. Releasing its half-yearly Economic Outlook , the OECD predicted that the UK would continue to lag behind most other leading industrial nations as it recovered from the deep downturn of 2008-09. Growth is projected to be 1.4% in 2011, rising to 1.8% in 2012 – weaker than ministers are expecting. The sluggishness of the economy will feed through into higher unemployment, which the OECD expects to rise from 7.9% of the workforce in 2010 to 8.1% this year and 8.3% in 2012 “Growth is projected to remain slow during 2011″, the OECD said. “Public consumption and investment are set to fall significantly while household consumption is expected to remain subdued, reflecting falling real incomes and stagnant asset prices.” The report added, however, that the Bank of England’s monetary policy committee would have to act before too long to curb inflation. With the government’s preferred measure of annual cost of living increases currently standing at 4.5%, the OECD said the public’s belief that inflation would remain high illustrated “concerns about the Bank of England’s willingness to tolerate significant and persistent deviations” from the government’s 2% target. “A modest increase in interest rates should be taken during 2011 to stave off increases in inflationary expectations, which are already elevated. As the recovery gathers momentum in 2012, the pace of normalisation of interest rates should be stepped up.” The OECD said the government’s mix of tax increases and spending cuts were needed to rein in the budget deficit, slow the build of the UK’s national debt and maintain the confidence of financial markets. “Nevertheless, consolidation measures should be implemented in a way that minimises the impact on short-term growth. Ending exemptions and increasing lower rates in the VAT system would increase efficiency and raise revenues that could be used to lessen cuts in infrastructure investment.” The thinktank also questioned whether the ICB’s proposal to ringfence the retail operations of banks within wider financial groups went far enough. “A full break-up of banks and further increases in capital requirements should also remain options”. For the 34-nation OECD as a whole, the economic outlook report predicted growth of 2.3% in 2011, rising to 2.8% in 2012. While noting that the recovery was becoming “self-sustained and more broad based”, the OECD pointed to significant downside risks including rising commodity prices, a sharp slowdown in China and the soveriegn debt crisis in the eurozone. “All this suggests that the global crisis may not yet be over”, said the OECD’s chief economist Pier Carlo Padoan. He added that policymakers needed to address four big challenges – high unemployment, sustaining growth, repairing public finances and managing global imbalances. “The global economy is exiting recession but is not returning to business as usual”, Padoan said. “The post-crisis economy will have to deal with old and new challenges, while pursuing new, green and inclusive sources of growth.” Interest rates Economics Bank of England Economic growth (GDP) Financial crisis Banking Larry Elliott guardian.co.uk