Crisis 'will get a great deal worse before it gets better' – but scope for rate cut

THE weakening British economy should allow the Bank of England to cut interest rates later this year, according to an influential forecasting group.

Despite inflation remaining above the 1% to 3% target range, the Ernst & Young Item Club expects the Bank of England to cut the base rate from its current 5% to 4% by the end of next year.

But the club's summer forecast due out tomorrow comes amid a warning that the economy is in danger of being crushed between the jaws of world credit and commodity markets, "with little prospect of early relief" and a substantial rise in unemployment.

It says that the Bank's Monetary Policy Committee "simply cannot cut interest rates while the risk of a wage-price spiral remains" and adds that "the Chancellor is certainly in no position to rescue us from this fate."

Peter Spencer, chief economist to the Item Club, which uses the Treasury's model for the economy, says the Government cannot afford to give in to striking public sector workers' pay demands. "We don't think the Government will cave in to the public sector unions. That would mean higher interest rates and a recession, which could cost them the election."

He also warns that conditions are likely to worsen. "Both on the high street and in the housing market it is going to get a great deal worse before it gets better," he says. "We have already seen a housing crisis that has morphed from a credit crunch to a general collapse in confidence as prices have tumbled. As Item has consistently warned, both consumer and the Government have been living beyond their means for the last few years, overborrowing on credit. Against the current bleak background, consumer spending is unlikely to defy gravity for any longer, while the public finances face a similar strain."

Spencer says the recession in property markets is "mutating and spreading" and that the wholesale funding problem has not been resolved. Demand for residential mortgages now seems to be falling faster than the supply as buyers hold back in the expectation of further price falls.

Construction, mortgage broking and related financial services have already been badly hit. "While the high street should avoid a recession, it is hard to see much growth over the next year," says the report.

He sees commodity prices as a continuing problem, in spite of last week's fall in oil prices. His report was written two weeks ago but he said yesterday that the price is still high "and these are terribly volatile markets", adding that "it only needs a US aircraft carrier to be seen anywhere near Tehran and oil will shoot to $200 a barrel".

The forecast shows growth falling back from 1.5% this year to just 1% in 2009. "As with any horror movie, there is an escape route but it is not an easy one," says Spencer. "It is imperative that wage increases remain restrained, despite the tremendous pressure from food and energy cost inflation. The economy will have to slow further to help secure this outcome. A general outbreak of wage inflation would spell disaster, requiring much higher interest rates and a recession in output to get inflation back under control."

The forecast assumes that wage and domestic cost inflation remains subdued, keeping the core CPI inflation rate close to its current rate of 1.6%.

Barring further hikes in commodity prices, that means the headline rate will come back into line with the target as this year's food and fuel price increases come out of the annual inflation calculation over the next 18 months. "On this prospect, the weakening economy should allow the MPC to cut base rates this winter without running the risk of inflationary second-round effects," added Spencer.

"We expect base rates to fall to 4% by the end of next year, helping to put a cushion under the level of demand in the economy and set the scene for a recovery in 2010. However, the margin of uncertainty around this forecast is much higher than usual."