UK economy set for biggest fall since 1945

The UK economy is forecast to shrink by 4.5 per cent in 2009 – the biggest fall in a single year since 1945. This gloomy prognosis comes from leading forecaster the Ernst & Young Item Club, the only one to use the Treasury's own forecasting model, and paints a materially tougher outlook than the consensus.

Peter Spencer, chief economic adviser to Item, said yesterday: "The economic patient has been in trauma, but thanks to the paramedics at the Treasury and the Bank of England who pumped billions of pounds worth of medicine into the economy, the patient has been stabilised for now. But it remains unclear how quick and complete recovery will be, and there is still a serious chance of a relapse."

But Item predicts that the sharp contraction this year will be followed by a modest recovery of 1.7 per cent next year. Professor Spencer warned that recent hopes of green shoots are "running ahead of reality", and predicted that we will not see a sustainable improvement in the UK economy until world trade starts to pick up. "Unfortunately," he said, "it is hard to see any very solid grounds for sustained optimism at the moment." He also said GDP could fall by as much as another 3 per cent if the threat of swine flu is as bad as the worst predictions.

The outlook is so tough, he added, because credit conditions remain so tight, while the current lack of competition in the banking sector means that lending to consumers and companies continues to be expensive.

"Capital remains short and expensive for the banks, and there is currently little sign of any extra lending to either companies or consumers. Banks are saying that they will expand lending more aggressively over the next three months, but it seems unlikely they'll come close to meeting the demand for credit," said Professor Spencer.

Item also predicts interest rates will stay at 0.5 per cent into next year and then will only increase by very small amounts for about 18 months. Despite efforts by the Bank to pump money into the economy through its quantitative easing (QE) programme, corporate liquidity and borrowing is still weak and net lending to the housing market remains close to zero.

Unemployment numbers, however, are not as high as predicted, as companies have reacted in a positive fashion to cutbacks by offering part-time work and other incentives to staff.

It is not just slower growth that the economy faces; it is also deflation, at least as measured by the Retail Price Index. It is now running at minus 1.8 per cent annually and seems likely to dip further. The key month will be September, for this is when the Treasury uses the RPI figure to set pensions, benefits and so on. The Treasury's forecast for the RPI in September is in the minus 2.5 per cent to minus 3 per cent range. Pensioners won't be hit, as the Chancellor has said he will raise the state pension by 2.5 per cent in 2010, regardless of the RPI. But the Treasury can save money, at least in one instance, by requiring housing associations to reduce rents, from April 2010, as many tenants are subsidised by the state.

Housing association rent increases are set by a formula of RPI plus 0.5 per cent. The associations wanted the formula altered so that if the RPI went negative they would not have to cut rents. But, on Friday, just as Parliament goes into recess, the Treasury slipped out that it will set an RPI "floor" of minus 2 per cent for rent-setting, so associations will need to reduce rents up to 2 per cent in the event of a negative RPI. This will cause real problems for social housing, undermining business plans, reducing service delivery and provision of new homes, and even threatening the viability of some associations.