8% interest rates could create double dip recession, says Policy Exchange

Britain is heading for a double dip recession, 8% interest rates and 10% inflation claims  Andrew Lilico,  chief economist at Policy Exchange.

Lilico does not believe the Bank of England will raise interest rates above 2% before late 2011 but they could hit 8% in the coming years.

And he says inflation and interest rates will rise rapidly at the same time too. 

He says: “Since interest rate rises will raise mortgage rates, the initial effect will be even more inflation.  In the early 1990s RPI inflation went above 10% off the back of rapid interest rate rises.

“I expect a similar level of inflation in 2012 – that would imply CPI inflation exceeding 6%, vs its recent peak of 5.2% in September 2008 — thus what I’m proposing is only a slightly larger overshoot of inflation than that only two years ago.  If we see no more than one year of inflation of above 10%, and no year of deflation of more than 5%, I shall consider the Bank of England’s policy to have been a resounding and surprising success.

“On the other hand, to keep inflation down to only 10% for one year, the economy will have to be able to tolerate interest rates of perhaps 8%  – note that interest rates were 7.5% in 1998, so the rates I am suggesting were very normal before the past ten years.

“But there is a risk that, between now and 2012, households will not take the opportunity to reduce their debts by enough, and so the economy will not be able to tolerate 8% interest rates without the mass defaulting on mortgages that we are trying to avoid.  If that is the case, then interest rates may have to be kept lower for an additional nine months and the consequence will be inflation peaking at 20% rather than 10%, as in the 1970s, when there were two years of inflation above 20%.

Lilico says his claims are not extravagant and that the City has lost its sense of historical perspective.

He says that being optimistic he sees the consequence of interest rate rises as another recession in 2013 or 2014.