Small businesses growth in the UK could be undermined by spiralling wage costs leading to even higher rates of inflation and further interest rate rises, the Chartered Institute of Personnel and Development and Ernst & Young Item Club have warned.

According to the latest index of small business performance by accountancy firm PFK, a broad rise in the number of small firms in the UK was accompanied by the biggest rise in orders in two-and-a-half years in the last quarter of 2006.

But there are fears that if wider economic conditions continue to worsen, small business growth may be hampered by soaring inflation and interest rates.

With new figures revealing inflation now stands at a three-year high of 3% - way above the government’s target of 2% - it is now feared that this month’s shock interest rate rise may be followed by further hikes in the near future.

The CIPD is warning companies of all sizes to resist the pressure to hand out pay increases to employees just because inflation is forcing the cost of goods up. It believes such price rises are the result of last year’s inflation and expects prices to fall later this year, meaning staff will see an increase in real, if not actual, wages.

“In approaching the winter pay round employers in all sectors will need to emphasise to staff that inflation will start to move back to target later this year come what may and that any squeeze on their incomes stems from last year’s rise in inflation,” said Dr John Philpott, chief economist at the CIPD.

“Trying to make up for this will only lead to further pain. But in getting this message across, sensible employers will ensure that calls for restraint apply right across their organisations, from the boardroom to the office and factory floor.”

A separate survey by the Ernst & Young Item Club also stresses the need to keep wage costs down in a bit to stem inflation.

It called on employers to judge pay awards based on the government’s target figure rather than the actual rate of inflation. “By the spring we should be seeing a decline in utility prices as the impact of lower raw material prices feeds through, coinciding with an increase in overall employment and an improvement in pay packets,” it said.

But the poll, which uses the Treasury’s own model to predict economic growth, provides a more optimistic outlook for the UK economy with a rate of growth of 2.9% for 2007 on the back of a boom in financial services and rising business investment.