Stephen King: Interest rates should come down but the damage to growth has been done

One year on, how does it feel? How does it feel to know that you can't sell your house? That you can't get a loan from the bank to buy a house or, for that matter, anything else? That unemployment is on its way up?

On either side of the Atlantic, it feels very bad indeed. For those who wish to clutch at straws, there are one or two pieces of good news. US output, for example, appears to have expanded at an annual rate in excess of 3 per cent in the second quarter, a welcome sign of resilience. Oil and other commodity prices have fallen, suggesting that inflation should come down a bit.

In general, though, good news is an increasingly scarce commodity. Consumers in the US and retailers in the UK are offering the same blunt message (see chart). For the man on the Clapham omnibus, the good times are over. According to Alistair Darling, who probably doesn't spend too much time on the Clapham omnibus these days, the UK is facing its worst economiccrisis in 60 years (although why he's singled out 1948 for special treatment is really anybody's guess).

To be frank, none of this should, by now, come as much of a surprise. For banks, the writing was on the wall last year. For the US housing market, in particular, the rot set in as far back as 2006. The consequence has been a credit crunch on a seemingly enormous scale, delivering a financial squeeze across lands and oceans. Whether it's the US, the UK, Spain or Ireland, monetary systems have seized up, paving the way for sustained economic distress.

Housing markets were strong only so long as banks were willing and able to lend to households. The banks' ability to lend, though, depended not so much on the size of their deposits – a factor which has become increasingly irrelevant in recent years – but, instead, on their knack of distributing mortgage debt to third parties. As confidence in the housing market has declined, so the ability to offload mortgage debt has dwindled. As a result the banks have simply been unable to maintain the largesse which, for a while, was the defining feature of credit markets.

For countries dependent on a debt "fix" – primarily those which ended up running huge balance of payments deficits – the collapse of the mortgage market has destroyed growth prospects. The mounting fear of recession owes a lot to the sudden turning-off of the debt tap.

This much, though, was already at least vaguely known a year ago. (Although, for Mr Darling, enlightenment had yet to arrive – back then, he said: "The world economy is currently strong and is well-placed to weather the storm.") Last summer, economic forecasters had to do some serious thinking. To what extent had economies become dependent on debt? How important was the mortgage-backed securities market? How over-valued were housing markets? And what was the likely response from policymakers?

Underneath all of this was the idea that, ultimately, a credit squeeze would be deflationary and, hence, bad news for growth. Surely, though, we all reasoned, inflation would not be a problem in these circumstances? Faced with a major restriction of credit availability, inflation was more likely to fall than rise. If there was, therefore, a silver lining, it came in the form of monetary flexibility. There might be a credit crunch, but at least central banks would be able to slash interest rates if needed.

That conclusion, though, has so far proved wrong, largely because of the unwelcome return of inflation. It's certainly true that the Federal Reserve, the US central bank, slashed its key policy rate down to just 2 per cent earlier in the year. Since then, though, there's been no further progress, despite rising unemployment, Fannie Mae's and Freddie Mac's problems and, to top it all, a housing market that seems to remain in freefall. The Bank of England would dearly like to cut interest rates further – in fact, the Bank's arch-dove, David Blanchflower, is demanding immediate action – but has so far been constrained by the insidious advance of inflation. The European Central Bank, which follows in the grand tradition of Germany's Bundesbank, eschews all talk of "bailing out" the economy: it would prefer a short-term loss of activity to a long-term rise in inflation.

It's easy enough to regard the rise in inflation as merely a temporary blip, a lagged response, perhaps, to the earlier period of economic excess. The problem, though, is that inflation has advanced far more aggressively than anyone expected a year ago. The table shows projections for growth and inflation in 2008 made during the course of last year from the IMF, the OECD and Consensus Forecasts. These numbers are then compared with the outcomes for the year so far. The big surprise in 2008 to date has not been growth but, instead, inflation.

The rise in inflation has hugely compromised the central banks' collective ability to deal with the credit crunch. Imagine inflation hadn't picked up. Where would interest rates now be? I'd hazard a guess that the Federal Reserve would have lowered its key policy rate to maybe 1 per cent or below. The Bank of England might have shoved its target rate down to as little as 3 per cent. The European Central Bank certainly wouldn't have had to contemplate the increase in interest rates it delivered a few weeks ago. Perhaps these additional rate reductions would have offered little solace. Nevertheless, during a credit crunch, the more interest rates can fall, the better the eventual prognosis for the economy.

Policymakers have struggled to come to terms with inflation partly because its arrival was so unexpected. After all, there's not a lot of wage pressure building up in the developed world. While it's easy enough to blame higher oil and other commodity prices for the rise in inflation, it's not at all obvious why these particular prices have been so buoyant: no Yom Kippur War, no Arab oil embargo, no Iranian revolution.

Arguably, the strength of commodity prices owes a lot to overheating in other parts of the world. Inflation may have risen a bit in the US, the UK and Europe, but the gains seen in the emerging economies have been much bigger. Many of these countries are what I'd call "growth maximisers", happy to accept higher prices so long as their economies continue to expand. This approach, the antithesis of the price stability aims of the majority of developed countries, has led to strong global demand for commodities which, through much of this year, has meant higher bills for the man on the Clapham omnibus. Faced with both a credit squeeze and a huge price increase, it's no great surprise that households are wilting under the pressure.

Interest rates should, eventually, come down. For growth prospects, though, the damage has already been done. If, as seems increasingly likely, the developed world ends up in an extended period of either recession or painfully weak growth, governments and central banks may be forced to rethink their approach towards macroeconomic management. After all, we already know that inflation targeting has not proved to be the source of economic stability many people hoped for. And we also know that our policymakers cannot even agree on what should happen if growth slows and inflation remains high: a three-way vote split on the Bank of England's Monetary Policy Committee is understandable, but it also reveals a lack of economic leadership when the good ship UK economy has found itself in unusually choppy waters.

Stephen King is managing director of economics at HSBC