Hamish McRae: The UK is caught in a vicious squeeze and hoping the BoE will cut some slack

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The Independent Online

We need to look beyond this cut in rates. This cut in rates so sure? Well it is conceivable that the Bank of England will not cut rates today but over the past few days such an outcome has become increasingly unlikely. Indeed the markets would be deeply shocked if the Bank were not to move.

There have been three main reasons for this shift in perceptions: what is happening to the housing market, to consumption and to the money markets.

The most obvious has been the deterioration in the housing market. Both Nationwide and Halifax are reporting falling prices, with Halifax saying prices are down three months running for the first time since 1995 so that prices, if annualised, would be falling at close to 10 per cent a year. The futures market in house prices would square with that, pricing in a 7 per cent fall in money terms for the coming 12 months.

Adding fuel to the flames was a comment by the FSA that up to 1.5 million borrowers would find it "difficult, if not impossible" to refinance their fixed-rate mortgages on reasonable terms when they fell due in the coming months. That must rank as one of the most stupidly-timed statements made by an official body. The time to warn people was when they were taking those mortgages out, not now that it is too late to do anything and when the number of new mortgage approvals was plunging. As GFC Economics pointed out in a newsletter yesterday: "The FSA is covering itself politically. But in doing so, it is making the classic mistake of overreacting after the bubble has burst, and in turn threatening to aggravate the credit squeeze."

Add in the impact of the home information packs, another piece of stupid timing, and it does look as though the housing market will gum up. Prices may not plunge in the coming year as much as predicted because these things take time to show through, but any forced sellers will be in trouble.

The second change has been prospects for consumption. The actual consumption and retail sales figures are not at all bad but they reflect the past rather than the future. Service industry growth is slackening and there has been a sudden deterioration in consumer confidence just reported yesterday. In the past, any decline in mortgage approvals has tended to precede a decline in retail sales. Certainly debt service costs have already become a serious burden on households, and on the Bank of England's calculations debt service accounts for almost as high a proportion of disposable income as it did during the early 1990s squeeze.

Add in the fact that thanks to the surge in the Retail Price Index, real incomes are rising by only about 1.5 per cent a year and prospects for consumption growth look bleak. Aside from a brief dip in 2002 real incomes are now rising more slowly than at any time since Labour came to power in 1997.

The third reason for the shift in perceptions has been the pressure on the money markets. You would expect the rates on the money markets to be a bit above the official discount rate, perhaps one-tenth of one percentage point for one-month money, maybe a bit more. This week the one-month sterling interbank rate has been just under 6.75 per cent, nearly a clear percentage point above base rate. That is a vicious squeeze. Cutting the Bank of England rate does not cure things because the problem in the markets is availability of funds as much as price, but it helps a bit. The job of any central bank is to maintain the appropriate credit conditions and it therefore does make sense to try to offset to some extent this unintended tightening of policy.

So that is where we are. What should we look for in the coming months? The first question is: how quickly will the economy slow down? The short answer to that is: a lot slower than the housing market. If you look at the US, or nearer home, Ireland, you see that consumption can carry on rising even when house prices are falling. In Ireland prices have fallen for the past eight months, so the market there seems to be running about six months ahead of the UK. Meanwhile in the US, Goldman Sachs reckons that housing weakness will knock two percentage points off growth in the coming year.

Even if the market forecasts for UK house prices are correct, we will be well into next year before the economy cools. It seems to me plausible that growth could slip down to 1.5 per cent next year, but remember there will be a series of interest rate cuts that will to some extent offset the effects of weak consumption. The City is pencilling in a Bank rate of 5 per cent next autumn and that seems realistic enough. The longer growth holds up, obviously the longer it will take for these cuts to come through. What I think is unlikely is really rapid rate disarmament. I cannot, for example, see rates down to 4 per cent or below until well into to 2009 and only if the UK economy starts flirting with recession at that point. I do remain more concerned about 2009 than 2008.

There will, however, be a difficult spring. There will have to be a budget. Already, even with growth at 3 per cent a year, public finances are under great pressure. It looks as though the deficit this fiscal year will be over 40bn, not the upwardly-revised 38bn disclosed by the new Chancellor in his pre-budget report. If growth slows as suggested above, that number, far from shrinking as intended, will climb away. He cannot credibly put up taxes without further caning the consumer and he cannot credibly increase borrowing to any significant extent. So there will have to be cuts in projected spending, disguised cuts to be sure but cuts none-the-less.

All this will take place against a slowing world economy. I have made the point many times that China is now big enough to make a material difference to global growth, for this year for the first time since I suppose the 19th century, China will add more demand to the world economy than the US. But we should all be aware of the danger of overplaying the extent to which the rest of the world can de-couple from America. To some extent it will; but the US still matters enormously and there is a real danger of recession there next year.

We will have to wait on the Bank today. There is, as argued above, a decent case for a cut on economic grounds but I hope the monetary policy committee members will be sensible and take the situation in the money markets into account, too. At least they won't be as stupid as the FSA.