Read the OECD Economic Survey of the UK in full

The Bank of England may have to cut interest rates because of a risk that UK growth will weaken as a result of the recent turmoil in financial markets, the Organisation for Economic Co-operation and Development (OECD) has warned.

In its 2007 Economic Survey of the United Kingdom, the OECD said: “The outlook for both growth and inflation has now become more uncertain and there is a risk that growth will be weaker going forward, which could imply a need for interest rate reductions.”

The forecast reverses earlier predictions the OECD had made for the UK economy. Before the recent market turbulence, it was forecasting that the UK economy would grow 2.7 per cent this year and 2.5 per cent in 2008.

The OECD also said that it expects market upheaval and the succession of interest rate rises from the Bank of England to lead to a slowing of the UK housing market.

It said: “The higher interest rates, together with the recent financial market volatility, are expected to have a moderating impact on consumer spending and slow the pace of house price inflation."

The Bank of England's Monetary Policy Committee will meet next week to decided whether to change the UK interest rates or keep it at 5.75 per cent.

The OECD commended the Bank of England's success in sticking close to its 2 per cent target for inflation.

Despite the rise in inflation to 3.1 per cent in March this year, mainly due to unusually large increases in gas and electricity prices, the OECD said: "It is a testament to sound monetary management, as well as to the stability of economic conditions, that it took ten years after the bank was given operational independence from the government before inflation moved more than 1 percentage point away from the inflation target."

Inflation has since dropped back to under 2 per cent.

The OECD expressed concern that many wage bargainers continue to base cost of living increases on the retail price index rather than the consumer price index.

The report warned that the use of the RPI as a basis for wage negotiations could push up wage inflation, and require a tighter monetary policy stance, and called for an alternative CPI index to include a comprehensive measure of housing costs.

It said that the Government should slow the pace of increases in the minimum wage "in order to foster employment of the low skilled".

The OECD cautioned that a slowing in growth, together with reduced profitability in the City of London, could reduce tax revenues and boost the UK’s budget deficit, and said action was needed to improve public finances.

“There is a need to reduce the government deficit, which will require much slower growth in government expenditure,” it said.

Over the next three years, the government is proposing to increase public spending 0.5 percentage points below GDP growth and consequently, the OECD said, the 2007 comprehensive spending review is expected to be tough.

In addition, the report also advised refinements to fiscal rules - notably, the “golden rule” which requires a balanced budget over the economic cycle, and the sustainable investment rule, which sets a 40 per cent of GDP limit for public sector net debt.

The golden rule relies on the notion of a clearly defined economic cycle, but this has become harder to identify as the economy has remained close to capacity over a long period, the OECD said.

Instead, the report said, it could be made less reliant on cycle dating and output gap estimates, and a positive target level for the current budget balance over the medium term could be introduced.

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