LONDON (Reuters) - Britain's economic recovery is gaining pace, but its apparent reliance on consumer borrowing and expectations of higher house prices may offer a shaky foundation for lasting growth.
A closely watched gauge of business activity across the services, manufacturing and construction sectors released earlier on Monday hit its highest level since records began in 1998, prompting economists to revise up growth forecasts.
This is welcome news for the government, whose critics have blamed its austerity policies for killing off the recovery that was underway when it took office in May 2010.
But the uncertain nature of economic growth also poses a challenge to the Bank of England, which on Wednesday is expected to take its first cautious steps in providing long-range guidance on future monetary policy.
Economists are now cautiously optimistic about Britain's growth prospects, but they warn that the recovery looks dangerously reliant on consumer demand and is a far cry from the export-led growth that the government, in the shape of finance minister George Osborne, had previously aimed for.
"What we would worry (about) is that we are getting an unbalanced recovery," said Jonathan Portes, director of the National Institute of Economic and Social Research, which revised up its growth forecasts last week.
"It could be sustainable in the sense that growth could go on for a year or two, but over the medium term it would not be what we need," he added.
NIESR forecasts growth of 1.2 percent this year and 1.8 percent in 2014 - a sharp improvement on last year's paltry 0.2 percent expansion and well ahead of 2013 forecasts from the government and the International Monetary Fund.
Britain's recovery from its last recession in the early 1990s was driven by business investment and exports following sterling's sharp depreciation after it lost its peg against the German mark.
But despite a similar depreciation against the euro in 2008, exports have thus far failed to recover, due in part to Britain's reliance on trade with the struggling euro zone.
Instead, the most recent gains in British economic activity appear to be linked to two factors that helped cause the last global financial crisis - debt-fuelled consumer spending and higher house prices.
Households have been able to raise spending in the face of falling real take-home income by cutting into savings and easier access to credit. Rising house prices have lifted consumer morale and helped restart construction activity.
Both are partly the result of government action. Last year the government and the Bank of England launched the Funding for Lending Scheme, which offers banks cheap finance if they increase lending, and in March Osborne announced a programme that subsidises home purchases.
While Osborne denied on Monday that his housing scheme risked creating a new bubble, many economists are concerned that it will fail to significantly lift supply.
And Portes said that a big fall in Britain's household savings rate either risked reversing sharply, and hurting consumption, or having a longer-term deleterious effect on Britain's ability to invest for future growth.
A third, more benign, reason for Britain's better growth outlook is the fact that for the first time in years, this August has not arrived with financial markets roiled by the threat of euro zone break-up.
"The absence of those strong headwinds and the presence of some tail winds from accommodative policy is what is driving this growth," said Jens Larsen, a former Bank of England economist who now works at Royal Bank of Canada. "Overall there is reason to be optimistic."
RBC predicts that Britain's gross domestic product will rise 1.0 percent between July and September - a pace of expansion which Britain last saw in early 2010 and up from a previous estimate of 0.5 percent. For 2013 as a whole it sees 1.4 percent growth, accelerating to 2.3 percent in 2014.
Larsen expects that cheap credit and increased consumer demand will translate into stronger business investment, but accepts that for now this remains "a leap of faith".
Inflation pressures are likely to remain muted - not least, Larsen added, because of continued spare capacity in Britain's labour market, as shown by an industry survey suggesting that one million people are employed on low-security 'zero-hours' contracts - four times the official estimate.
But the Bank will still face a tricky balancing act ensuring that signs of growth do not bring calls for it to consider raising interest rates from their record-low 0.5 percent.
To this end, Governor Mark Carney is expected to announce unprecedented long-range guidance on interest rates later this week, either committing to keep rates unchanged for a certain period or tying rate rises to a fall in unemployment.
"It certainly highlights why it might be a good idea to have forward guidance in place, if growth is going to be volatile and that the sustainability of the recovery remains in question," Larsen said.
"If you believe that, the last thing you want is a sharp rise in interest rate expectations."
(Editing by Jeremy Gaunt.)