Rates set to rise early next year

A Bank of England sign is seen outside the Bank of England in London November 9, 2006.

LONDON (Reuters) - Britain faces a long road to recovery and growth will be modest in 2010, but that will not prevent the Bank of England from raising interest rates early next year, according to the Confederation of British Industry.

In its latest quarterly economic forecast, the lobby group said it reckoned the BoE will start raising interest rates from their record low of 0.5 percent from next spring to reach 2 percent by the end of the year.

The CBI says policymakers will be keen to return rates to more "normal" levels, even though it forecasts growth of just 0.3 percent in the first two quarters of 2010 and says there is a large degree of spare capacity in the economy.

"It (the BoE) will be keen to start to restore normality to monetary policy," CBI chief economic adviser Ian McCafferty told a news briefing.

"We're not suggesting rates will be going back anywhere near neutral, around 5 percent, but 2 percent is still stimulatory for the economy."

Most city economists reckon the central bank will not start tightening policy until late 2010 at the earliest, as the BoE has forecast that the weak economy will put downward pressure on inflation, pushing it below its 2 percent target by mid-2010.

McCafferty also reckons the central bank will start unwinding its 200 billion pound asset-buying programme -- aimed at hauling Britain out of its deepest downturn in decades -- in late 2010.

The CBI estimates the economy will grow by 1.2 percent next year and 2.5 percent in 2011, well below government forecasts.

But it no longer sees unemployment hitting 3 million next year and now reckons it will peak at 2.8 million in the third quarter of 2010.

Still, the business group warned of hurdles on the road to recovery and said it could be years before economic output returns to its pre-recession levels.

"The UK economy faces a number of structural hurdles over the coming two years, and this recovery -- like that of the 1980s -- will be relatively drawn out," McCafferty said.

"Credit conditions will remain difficult as the banks slowly nurse themselves back to health, consumer spending will be shaped by the need to rebuild savings, and the public sector will soon have to tighten its belt. All three factors will act as headwinds to growth."

(Editing by Toby Chopra)