Alert over slump by Christmas

BRITAIN could be in the grip of deflation - a nationwide slump in wages and prices - by Christmas, according to Item, an independent economic think-tank

With signs that the nation's long-moribund manufacturing industry is bouncing back from the dead, the Bank of England may be tempted to raise interest rates for the first time since February 2000.

But that would be devastating for the millions of people who have run up record levels of consumer debt, warned Item economist Peter Spencer, a professor at York University.

Frightened by higher rates, the consumer could stop spending and trigger a general crash in all prices for the first time since the Great Depression of the Thirties. 'Deflation is a very real possibility,' he said. 'We could see falling prices by Christmas.'

Item, which uses the Treasury's own computer model of the economy, said that if prices tumble by the end of the year, the effect would be to boost the burden on Government borrowing in 2005. The projected £24 billion would rise to a crushing £80 billion as the state grappled with soaring unemployment and sinking tax revenues.

Until now, weak manufacturing and export industries have persuaded the Bank to hold interest rates at levels not seen since the mid-Fifties. But tomorrow's production industry figures for July are tipped to show a further modest improvement in manufacturing output.

Ross Walker, economist at the Royal Bank of Scotland, said: 'We know there was a pick-up in industrial production at the end of the second quarter and the evidence from private surveys has been picking up as well.

'The Bank of England will be looking closely at these figures. The consumer has been keeping the economy going, but consumer spending as it is at the moment is not enough to persuade the Bank to raise rates.

'Solid industrial recovery, however, could be just the reason it needs to put up the cost of borrowing.'

But Spencer said this could be a crucial mistake. 'We fear the Bank will decide to fire a shot across the consumer's bows and that this will send the economy into general deflation. 'People are talking about a rate rise this year and I certainly wouldn't rule that out.'

But, he warned, once deflation sets in, it is very difficult to cure - as shown by the Japanese experience of the past ten years.

'We are on the edge of a very slippery slope,' warned Spencer. 'When you are on that slope you keep going.'