The outlook is rosy for the UK economy this year, according to research by accountants Ernst & Young.

The firm's Item Club forecast predicts strong growth and below-target inflation, but tighter profit margins which could hit investments and jobs by next year.

Shoppers are set to be the main winners, with the economy predicted to grow by a robust 3.5%, while inflation is expected to remain at around 2% - below the government's 2.5% target.

The growth estimate is well above Chancellor Gordon Brown's forecast of 2.5% to 3% made in his pre-Budget report last November. The Ernst & Young report has factored in stronger data for the economy, particularly in the case of exports.

The analysts expect the Treasury to do the same.

The researchers also predict more interest rate rises this year, but say that the cost of borrowing will peak this summer at 6.5%, well below the last peak of 7.5% in the summer of 1998.

Interest rates currently stand at 5.75%.

With rates remaining at such levels, house prices are expected to keep rising, adding about 14% to the value of the average house.

Professor Peter Spencer, economic adviser to the Item Club, said: "Consumers will be thrilled, and the government's election planners will be salivating at this prospect."

Net effect

Professor Spencer warned that there some clouds on the horizon.

He said companies would find themselves squeezed as shoppers remained unwilling to pay higher prices while wage and raw material costs kept increasing.

Shopping via the internet and government inquiries into financial products, food and car pricing meant consumers could stand firm on prices, he said.

"That's why consumers will win, but at the expense of business."

Profits growth could also be hit by the strength of the pound - which is not expected to wane.

"Behind the headline figures lie tightening profit margins and meagre profits growth which could affect investment and jobs 18 months down the line," he warned.

Ernst & Young's Item Club forecast uses the Treasury's own economic model to predict the outlook for the economy.

The forecasting group is named after its system - the Independent Treasury Economic Model.