The fiscal tightening implemented by the new coalition should not choke off the recovery, but it will slow UK economic growth over the next two years, according to the latest Ernst & Young ITEM Club forecast.

Peter Spencer, chief economic advisor to the Ernst & Young ITEM Club, said:“The new coalition’s plans to cut the deficit are certainly ambitious. But the bulk of the additional tightening is set to come in the second half of the parliamentary term, when we believe that the recovery will be firmly entrenched and the economy should be able to deal with the headwinds from the Budget.”

Spencer added:” On the assumption that the government is able to implement the overall reduction of £40 billion set out in the budget, we expect that UK growth will struggle to reach 1% this year but will gradually speed up in the following years to give the UK a high-quality recovery based on trade and investment.”

Spencer stated that the recent VAT rise will help to plug the fiscal black hole over the following 12 months. But he cautions that after that the medium-term forecast for the UK economy is fraught with uncertainty. “The medium-term outlook for growth, inflation and interest rates is critically dependent upon the coalition’s ability to cut back spending.”

High energy prices and the increases in VAT will keep CPI inflation above target over the next 18 months, but ITEM believes that it will then move well below 2% as these effects wear off and spare capacity bears down on pricing decisions and wage bargaining.

To prevent CPI inflation moving below 1% ITEM say it will be necessary keep the Bank base rate low at 0.5% for much longer than the OBR and the markets have anticipated.

The latest forecast suggests that the BOE base rate will remain on hold until the end of 2013, although this is dependent on the assumption that the impending spending cuts actually come through.

Spencer said: “A base rate of 0.5% will begin to look like the new normal.”