Hamish McRae: Inflation and interest rates may be on the way down but the finance famine is far from over

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A year on from the start of the credit crunch and the pressure on the banks is as great as ever. But its impact has hit different parts of the economy in a sequence: first housing, then retailing and only now the economy as a whole, though here it is hard to differentiate between the effect of the crunch and that of higher fuel and food prices.

Some countries have fared worse than others. The UK economy has continued to grow into the third quarter. We don't have official GDP numbers yet, but the National Institute of Economic and Social Research does a pretty accurate estimate and it reckons that growth continued through July, albeit slowly. The US, boosted by tax cuts, has gone on growing too, again slowly. But Japan seems to be entering recession, while Germany and Italy had negative growth in the second quarter.

This is counter-intuitive. You would have expected the countries with large financial services sectors and housing bubbles, such as the US and UK, to do worse than those with strong merchandise exports and no surge in house prices, such as Germany and Japan. But the reverse seems to have happened: the profligate are scrambling through and the virtuous have been clobbered. I don't think anyone fully understands why this should be but it certainly does not seem fair.

So far as the real economy (as opposed to the financial sector) is concerned, these are still early days. For the UK, I still think next year will be more difficult than this and I am beginning to worry about 2010. Next month we will get some sort of package designed to boost the housing market: the Treasury is working on that now, as Alistair Darling has hinted. But given the numbers – the value of the housing stock falling by a billion pounds a day – it is hard to see the odd few billions of public funding making a difference. Besides, the Government has to borrow the money, thereby competing against the banks and building societies for savings.

This leads to a further issue: the struggle some of the banks seem to be having to attract deposits. It would be irresponsible to name them, but just looking at the rates that some are offering for deposits, it is clear they are under huge pressure. Several are bidding between 6 per cent and 6.5 per cent for three-month money, a whopping premium on a base rate of 5 per cent. At least one large money manager has dropped some banking groups off the list of places where it is prepared to place deposits – another sign of the jitters.

While the banks struggle to attract deposits, they are not going to be looking for new business. The home loans market has worsened in the past few weeks and not only because would-be borrowers want to hold off in case of a stamp duty holiday. (Did nobody warn the Chancellor that this was the one certain way of making people delay buying a house?) Large development projects are being put on hold partly because falling property prices are narrowing the headroom but also because the finance is no longer available even for sound propositions with plenty of equity. I heard of two such projects, one small and one big, being shelved last week.

It is not yet clear whether this financing famine has spread beyond property and associated businesses. Until a month ago there was no obvious financing distress. Some companies have been hit by the downturn in demand and the rise in energy prices, of course, but if you look at the economy as a whole, there was little evidence of businesses coming under pressure – halting investment projects or, more crudely, paying their bills late.

The problem of getting a fix on this is that it takes a long time for anything to show up in the statistics, so you have to rely on anecdotal evidence. But I get the feeling that things may have deteriorated in the past few weeks, with companies that had previously felt secure going into survival mode and seeking to conserve cash at all cost.

If this sounds disturbing, it is worth holding on to a basic truth: the more restricted the supply of finance, the cheaper it can become without stoking inflationary pressures. So the scope for interest rate cuts is greater. From the wealth management division of Barclays the rates will come down swiftly next year, with the Bank of England base rate starting to be cut early in the year and coming down to 4.25 per cent by the autumn. That would imply a fall in the three-month money rate to below 5 per cent – a sharper decline than currently priced into the markets. My view is that the first cut could come by this autumn.

Will the Bank's Monetary Policy Committee have the leeway to do this? That depends on inflation, which in turn depends on food and energy prices. Increases in these led to the global surge in inflation, for the prices of most goods and services have otherwise remained reasonably flat. As the price of energy falls it will help cut global food prices.

Once food and fuel prices stabilise, the previous surge moves out of the inflation numbers over the next 12 months. As long as they don't rise any further, inflation inevitably comes down. Were they actually to fall, which is surely quite likely, then inflation could come down very fast indeed. It is even possible that we could have the consumer price index down to 0.5 per cent in a year's time.

That would, however, require global demand for energy and commodities to ease. Could that happen? They are the tiniest straws in the wind, but Chinese manufacturing production fell last month, while Beijing housing sales were 60 per cent down year-on-year. I am not saying that China is about to go into recession – just that the economy there will probably slow once the Olympics are over. That would trim many commodity prices since China is the world's largest importer of commodities.

The moral is that it is possible both inflation and interest rates could come down more swiftly next year than the financial markets expect. So the problem would become even more explicit: though money will be cheaper, getting a loan will remain tough. Supply will be the problem, not price.

Time for the Bank to square up to the Treasury

The main focus of the UK data coming out this coming week will be inflation: the quarterly Inflation Report from the Bank of England (on Wednesday) following producer prices on Monday and consumer prices on Tuesday. There will inevitably be a mass of comment about and interpretation of the numbers and the Bank's perception of the likely inflation profile: this will lead to the obvious "when will the first cut in rates come?" stuff.

Something else, though, may have more political resonance; the Bank's growth forecast for the UK economy. The question there will be how much more gloomy the Bank will be than the Treasury about growth this year and next. One of the good things about the independent status of the Bank is not just its interest rate setting independence but a greater freedom to speak its mind on economic numbers. It is really completely free from the Treasury on this score. Expect its numbers for this year to have declined even further but that is obvious. What will matter more will be the forecast for next year.

Just last week, the International Monetary Fund forecast 1.1 per cent for 2009 (after 1.4 per cent this year). If the Bank comes in about there the implication will be for a government borrowing requirement of some £60bn. And if growth comes in below 1 per cent next year then public finances are in desperate trouble.

The people in the Treasury know all this, and what they have to do about it, though it may not be this Chancellor that has to present their work. The emergency housing package will come out in September but after that the next task will be to create a credible pre-Budget report in October or November. The fiscal rules will have to be re-written but that may not be enough to restore credibility. You can see how weak sterling has become, a bad sign that the markets are aware of the scale of the fiscal disaster the Government faces. So will there be spending cuts?

How the Government digs its way out is not the Bank's concern, nor should it be. But I could see this Inflation Report as the Bank squaring up to the Treasury ahead of the most difficult autumn since the early 1990s.

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