Interest rates 'should stay' at 0.5% says Item Club

The EY Item Club says wage growth should be evident before a rate rise

Interest rates should be held at 0.5% until squeezed real-term wages begin to grow - to avoid choking the recovery, a leading economic forecaster has said.

The EY Item Club urged the Bank of England to bolster its guidance policy which says it will not consider a rate rise until unemployment falls to 7%.

This was likely to be met in 2014 - two years earlier than expected, it said.

But wages remained subdued, it warned, urging the Bank to factor this into its policy pledge.

In its latest quarterly report into the health of the UK economy, the EY Item Club said raising interest rates too soon, before "real wages" had shown an improvement, could risk "choking off the fragile consumer-led recovery."

The BoE policy whereby an unemployment figure is regarded as a target is known as forward guidance. The governor of the Bank of England, Mark Carney, set out a forward guidance strategy to accompany his first inflation report in August of last year.

But policy makers have stressed the 7% threshold is not an automatic trigger, and will instead simply mean a rate hike can be considered - while taking other key factors into account.

The EY Item Club report predicts that unemployment will fall below 7% in the first half of 2014, but that wages will grow only 1.8% in 2014, before rising by 2.7% in 2014, and 3.5% the year after.

'Spending sprees'

The group adds that the BoE Monetary Policy Committee, which sets interest rates, should supplement a forward guidance threshold with an additional measure of wage growth - it also says the 7% unemployment marker should be lowered.

UK consumer spending has boosted the economy

Peter Spencer, chief economic advisor to EY Item Club said: "It is hard to find another episode in time where employment has been rising and real wages falling for any significant period of time. The weakness of real earnings is proving to be the government's Achilles heel and could prove to be the weak spot in the recovery.

"Consumers have reduced the amount they save to fund their spending sprees. But they cannot continue to drive growth for much longer without an accompanying recovery in real wages or a rise in their debt to income ratio."

The EY Item Club view is shared by a number of economists.

Earlier this month in a snapshot of opinions of the UK's top economists from the BBC, an overwhelming majority - 93% of the 28 economists polled - said they thought rates would still be 0.5% at the end of 2014, with more than half predicting the first rise in the second half of 2015.

More than 40% believe unemployment will fall to 7% in 2014, from 7.4% now.

On the economy as a whole, the EY Item Club said consumers would continue to propel growth, and that UK GDP would expand 2.7% in 2014 - up from 1.9% in 2013.

Consumer spending, despite slow wage growth has been regarded as a driving force for the UK economy in the past 12 months.