We all knew that prospects for the UK economy were darkening, didn't we, but it was only last week that the authorities caught up.
Just to recap, there were two main announcements. One, from the Bank of England, forecast that inflation would be much worse than previously acknowledged, with the strong indication that there would be little or no scope for interest rate cuts for the next 18 months. The other, from the Chancellor, was that £2.7bn of tax cuts would come in from the autumn, as part of the package to offset the loss of the 10 per cent tax band.
So we are going to have a somewhat tighter monetary policy than was on the cards a week ago and a slightly looser fiscal policy than was set out in the Budget. The tighter monetary policy is in response to greater-than-expected inflation; the looser fiscal policy is in response to a greater-than-expected protest from Labour backbenchers. Without this concession, the Chancellor might not have been able to get the Finance Bill, which puts into law the proposals of the Budget, through Parliament. That would have led to his resignation, which would have been a bit rough since it wasn't his idea in the first place.
A tighter-than-expected monetary policy will put more pressure on the housing market. The reasons for it are shown in the first graph above, taken from the latest and previous Inflation Report. The Bank produces its expectations for both inflation and growth in the form of a fan chart: there is a central point but with a fan on either side showing the decreasing probability of other outcomes. For clarity I have taken only the centre point but you can see how the Bank's expectations of inflation have worsened between February and May, with the consumer price index now expected to rise well above 3 per cent (where it is now) and stay there for most of next year.
The actual inflationary situation is worse, for the CPI tends to understate it – the long-established retail price index is now 4.2 per cent – so the inflation we all feel will be higher still.
Since the Bank is supposed to hold the CPI down to 2 per cent, the scope for cuts in rates is at best very limited. I don't think we should rule out the possibility that the next move in interest rates will be up. That is a really sharp change in perception from even a week ago. But then the change in the Bank's forecast is equally sharp. So what does this mean, most obviously for the housing market but also for the wider economy?
Those of us who thought that UK house prices would be on a long plateau for several years, maybe with modest declines but no sudden crash, may now turn out to be wrong. One of the assumptions behind the plateau theory was that if necessary the Bank would be able to cut interest rates. But it may not. Add to that the possibility that, as at present, the gap between official interest rates and money market rates remains close to a full percentage point. Add the further issue of mortgage availability remaining very restricted. Suddenly you do have the conditions for quite severe declines in house prices. We know the Cabinet was briefed that prices this year would fall "at best" by 5-10 per cent. Given the interest rate outlook, it is prudent to assume there will be further falls next year and beyond.
So let's assume that prices do fall over two to three years by an overall 20 per cent from their peak and that there is no real recovery for five or six years. What then? The frame of reference we have is the early 1990s. This decline would be somewhat greater than that, particularly in real terms because there was rather higher general inflation then. The duration of the slump, however, would be about the same.
The biggest difference would be that we are unlikely to have a similar surge in unemployment as occurred then. There are no mainstream forecasts of prolonged recession for the UK, at least not yet. The Bank's Governor said it was possible that we might dip into one but that this is not the Bank's central forecast. What is starting to happen, though, is that forecasts are coming through for 2009 that show growth lower than in 2008: for example, ING Bank has it at 1.5 per cent this year but only 1.0 per cent next.
It is virtually impossible to predict growth 18 months ahead but the idea that 2009 will be more of a problem than 2008 does seem to be taking hold. The Treasury forecast of some slowing this year followed by a recovery next is for the birds.
That has two consequences. One is a long squeeze on consumption. The second graph shows how the forthcoming squeeze might compare with the early-1990s one. The forecast from Capital Economics suggests consumption growth will be very low but not quite go negative, as it did then.
The other consequence will be on public finances. The deficit in the 2008-09 fiscal year will now be about £45bn, thanks to that extra £2.7bn of tax cuts, equivalent to a bit over 3 per cent of GDP. But that is £45bn, assuming that growth is within the Treasury's forecast range of 1.75-2.25 per cent. All right, we get though this year with a bit more borrowing and with numbers that can just about be shoehorned into the Government's borrowing rules. But what about next year and the year beyond?
The basic point is inescapable: we are going into a global downturn. Ideally you would want to offset any decline in demand by having looser monetary and fiscal policy. But we cannot have a significantly looser monetary policy for the reasons made clear by the Bank. And we cannot have a significantly looser fiscal policy because we are already bumping against the Government's self-set borrowing limits. The Chancellor has just used up the tiny bit of ammunition that he could scrape together to buy off the backbenchers.
Something will give and we know what that will be. It will be the borrowing requirement. We all sort of suspected that and last week we had confirmation. That extra borrowing will not be the last. You could write the speech now: how the global circumstances were unprecedented and how under these circumstances the Government deemed it prudent to allow a modest and temporary rise in borrowing above limits set under quite different circumstances.
Eventually debts have to be repaid, even government ones. But that will be a dance for the next Chancellor to choreograph.
Crumbs of comfort for millions who need them most
It was principally soaring global food and energy prices that shifted the Bank of England's inflationary expectations but the impact on the UK, or any developed country, is limited in comparison with the developing world, where food accounts for a much greater proportion of household budgets.
So it comes as a slight relief to see the price of one staple coming down: wheat. This is now lower than it was six months ago, in contrast to maize, which is some 50 per cent higher. Why? One factor inflating the price of maize is that it is being used to produce ethanol in the US.
But you cannot just blame US policy for global food prices. It would be encouraging to say that the cost of other staples was also falling but I am afraid that rice, hugely important in Asia, is not. In fact, it has been moving pretty much in line with maize, and last month was continuing to rise. Still, the impact of cheaper wheat and a fall in the price of some other foods meant that the UN's Food and Agriculture Organisation could report an easing in its composite food index for April, published last week.
That was the first such decline since January of last year, so a tiny chink of light: the FAO was cautious of predicting further declines but the price of food doubled, on average, in little more than year, the possibility of a plateau is most welcome.
And energy? Not much good news, I fear. The West Texas price (a little higher than Brent) reached nearly $128 a barrel, a new record, on Friday and my suggestion here a few weeks ago that a peak might be in sight looks wrong. But markets do overshoot and what is happening is concentrating minds wonderfully. Large users of energy are trying to figure out how to use less of it. For example, the speed of ships is being cut as it is cheaper to use more ships travelling slowly than fewer ones going faster.
In the long run this is a really important contribution to conservation ... but the long run is, well, the long run.