Jeremy Warner: Don't count on a rapid bounce back

Outlook The Bank of England is forecasting a short, sharp recession, no worse in terms of its depth than that of the early 1990s and with growth returning to above trend in early 2011. The Chancellor seems to agree (see interview, page 8).

Just three months ago, such a prognosis would have seemed quite bad enough. Against many of today's doom-laden predictions, it looks almost optimistic.

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The Bank of England's latest forecasts take no account of anything the Government might do to reflate the economy in the pre-Budget report through tax cuts or increased spending. Factor in a big reflationary boost and the outcome might be less painful still.

Is the Bank of England right to be so sanguine in its view of the downturn? The Bank has been proved too optimistic, some might say wrong, on its outlook for growth for quite some time now, and prior to that it also took too relaxed a view of prospects for inflation.

This has arguably led to a series of mistakes in monetary policy, with the Bank in the first instance too slow to act on the inflationary threat, and then too slow to recognise the seriousness of the economic downturn.

At his quarterly press conference yesterday to release the inflation report, Mervyn King, the Governor of the Bank of England, was asked whether he would like to apologise to all those who had lost their jobs because of the Bank's failure to slash interest rates at an earlier stage.

Mr King declined, arguing with some degree of justification that the world changed after the collapse of Lehman Brothers, when the banking crisis turned from a storm into a full-scale hurricane and previously elevated commodity prices halved.

Once that had happened, policymakers acted swiftly, firstly to recapitalise the banks so that they could carry on lending, and then by slashing interest rates. Prior to these events, the economy had been slowing fast, but the threat from inflation remained very real. If you cannot make better policy with the benefit of hindsight, the Governor points out, then you really would deserve to be fired. Unfortunately, the Bank's Monetary Policy Committee is made up of human beings and is therefore not blessed with perfect foresight.

This would all sound plausible enough were it not for one slight fly in the ointment. At least one member of the MPC, David Blanchflower, did see it all coming and has been urging the case for easier monetary policy for the best part of a year now.

Mr Blanchflower is the main witness for the prosecution, but he is by no means the only one. Others too have been arguing for quite some while that there is far more spare capacity in the UK economy than the Bank seems to think, enabling it to run a low interest rate environment without danger of stoking inflation. Their advice went unheeded.

What is indeed true is that things got a lot worse from September onwards. First Alan Greenspan, and yesterday Mervyn King and the US Treasury Secretary, Hank Paulson, all of them have now cited the famous Keynesian remark that when the facts change, they change their minds.

Within the space of two months, oil and other commodity prices changed from having recorded their biggest-ever quarterly gains to showing their biggest ever quarterly losses. The stock market also experienced its worst monthly fall since the 1930s and economic activity fell precipitously.

Now that we are down in the doldrums, it is easy to forget quite how dramatic and swift the scale of the turnaround was. Many of those who lambaste the Bank for monetary failure are just trimmers who have been equally guilty of misreading the runes. Their own failure to predict the future is now conveniently forgotten. In any case, what's done is done. The more immediate question is whether the Bank is compounding past misjudgements by retaining too optimistic a view of the outlook for growth. As I say, the recession now forecast is quite bad enough, being comparable in size and duration to that of the early 1990s, but a relatively rapid bounce back is being predicted with the economy again growing from late next year onwards.

Support for this view seems to be taken largely from experience of the Swedish banking crisis back in the early 1990s when rapid action in nationalising and recapitalising the banks quickly succeeded in putting the economy back on its feet.

This was in sharp contrast to Japan, where failure to address the banking crisis at an early enough stage condemned the country to more than a decade of deflation. Japanese officials were apparently unusually passionate in urging the case for recapitalisation and sharp interest rate cuts on their Western counterparts at the recent meeting in Washington of the IMF and World Bank. They've had to learn the hard way what happens if you delay. Yet beyond faith in the power of public policy to deliver the goods, the Bank's case for a rapid bounce back looks unconvincing. Britain will get some benefit from the collapse in sterling, which accelerated further yesterday, but this may be quite limited in circumstances where there is little demand elsewhere in the world either.

Lower mortgage costs and now fast-falling inflation should provide a boost to squeezed disposable incomes, but again this may not have much effect if householders use their extra pounds to pay down borrowings or otherwise rebuild savings.

The Bank's forecasts take no account of anything the Government might throw at the economy, yet without a helping hand, it is hard to see why things would recover as quickly as foreseen. Recapitalisation of the banks may have stopped a veritable collapse in lending, but it won't prevent a more gentle process of deleveraging, and if the banks are reducing their lending, the economy will struggle to grow.

Bankers are desperate to pay off or run down the capital they have been obliged to take from the Government. The quickest way of doing this is to reduce the size of the balance sheet. It is not immediately obvious why this would result in an early return to above-trend growth.

As for reflationary policy from the Government, it may help, but as Mr King observes, unless temporary and accompanied by a clear-cut plan for getting the public finances back on the straight and narrow, the benefits will only get lost in higher interest rates. There is no easy path back to growth. That the Bank thinks there might be is something of a puzzle.