Jul 11 2008
By Roger Bootle, Economic Adviser to Deloitte

It is too late for the Monetary Policy Committee to prevent the economy from slipping into a recession. And lingering inflation fears mean that it probably won’t be until late this year that the Committee is able to cut interest rates to limit the depth and duration of the downturn. The economic outlook is more grim now than at any point since the early 1990s, when the level of GDP fell by 2.5% and unemployment rose by 1.4 million.

The extent of the weakness of the news on activity in recent weeks has been breathtaking. While a recession (as defined by two consecutive quarters of falling output) looked like the worst case scenario a few weeks ago, it now seems like the most likely, and appears perilously close to boot.

According to the Nationwide, house prices fell in each of the eight months to June and by 8% in total. And the drop in the number of new mortgage approvals in May to even further below the lows seen during the early 1990s crash suggests that this is just the tip of the iceberg. It is becoming increasingly likely that by the end of 2010 house prices will have fallen by a third.

And the housing sector is not the only area that is suffering. The recent profit warning by Marks and Spencer and the sharp drop in sales announced by John Lewis suggest that consumers are in no mood to spend. Indeed, consumers are more concerned about the economic outlook and their own finances than at any point since 1991, when interest rates were at 14% and 2 million people were unemployed. Even manufacturers, who should be benefiting from the sharp fall in the pound, are feeling the pain. In fact, the industrial sector is probably already in recession.

But the news on inflation means that the MPC is almost powerless to respond to the weakening in activity. CPI inflation is set to rise from its current rate of 3.3% to around 4.5% by the autumn, prompting a string of letters from the MPC to the Chancellor explaining why inflation is so high. And if rumours that utility suppliers intend to raise their prices by 40% prove true, it could peak at over 5%. What’s more, the public’s inflation expectations are reported to have risen to yet another record high in June.

Admittedly, there has been little evidence that the rises in food and energy costs are feeding through into the prices of other products or wages growth. But with the UK’s low-inflation climate more at risk now than at any point in the last decade, the MPC will not want to take any risks. It will probably not be able to cut interest rates until late this year at the earliest.

But this will only exacerbate the economic downturn that appears to be gathering pace by the day. I still think that interest rates will have to fall very sharply, perhaps to 3.5% next year. But this will come too late to save the economy. Even if the UK were somehow to avoid a recession, it is clear that it is set for a long period of very weak activity.