Why the recession became inevitable

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The Independent Online

The UK's official plunge into recession was all but inevitable in recent months as the financial crisis escalated in the wake of the devastating credit crunch.

Economic output has been on a downward course since the squeeze in credit markets struck in 2007, leading to a lending drought that has crippled banks, households and businesses.

Britain's housing market has been hammered as mortgages have become scarcer and dearer, while the economy's key services and manufacturing sectors have also suffered some of the worst activity levels in decades.

The Bank of England has only recently come to the country's aid with much-needed interest rate cuts, having effectively had its hands tied until late last year by rampant levels of inflation.

Consumer Prices Index (CPI) inflation rocketed to a peak of 5.2 per cent last September - more than double the Government's 2 per cent target - amid soaring oil and food prices.

The cost of crude reached nearly 150 US dollars a barrel, while food price inflation raced to 10 per cent at one stage last year, hitting household and businesses alike - and putting a further squeeze on consumers who had less money to put into the economy.

The Bank, determined to keep the inflation genie in the bottle to avoid a return to the 1970s, started lowering rates only in October and has since been playing catch-up, dropping the base rate to a historic 315-year low of 1.5 per cent earlier this month.

But inflation has fast turned into yesterday's problem as the impending recession has already led to a sharp decline in demand and economic activity worldwide.

The collapse of investment bank Lehman Brothers last autumn sparked off a devastating new phase of the credit crunch, bringing the global banking sector to its knees and effectively sealing the economy's fate.

Iceland's economy came close to complete collapse, while a raft of banks across the UK and globally had to be rescued and taken into public ownership.

Despite a mammoth Government bail-out, British banks have still not resumed normal lending, which has had a knock-on effect across all sectors of the economy.

Mounting job losses saw unemployment increase by 131,000 to 1.92 million in the three months to November to the highest level in more than a decade, figures revealed earlier this week.

Company failure rates are also rocketing, with well-known brands MFI and Woolworths among dozens to have been placed into administration in the past two months.

In the manufacturing sector survey, data this week showed activity slumped to its worst since July 1991 over the past three months, with the outlook the bleakest in 28 years.

While economic output has been slowing since mid-2007, the pace of decline has sharpened considerably since last autumn, and more than experts initially expected.

Policymakers were aiming for a gradual slowdown in the UK economy with five rate hikes in the run-up to July 2007 but the dual pressures faced by the UK have led to a harder landing than first thought.

Chancellor Alistair Darling's early forecast for growth of between 2 per cent and 2.5 per cent for 2008 is now shown to be woefully optimistic.

The annual rate of output in 2008 is also a far cry from the 3 per cent seen in 2007.

This year is predicted to be far worse, with the economy forecast by some to shrink by 2 per cent or even closer to 3 per cent in what could be the biggest decline since the Second World War.

Bank of England governor Mervyn King said this week that the recession was tightening its grip and that it may need to turn to "unconventional measures" to control inflation as interest rates come close to zero.

The recession is expected to continue in the first half of this year, with "further marked falls in output", he warned.

Now as the recession reins in demand and firms' ability to set prices, the prospect of deflation has emerged as the new headache facing policymakers. CPI fell to 3.1 per cent last month from 4.1 per cent in November and is set to fall fast over the coming months.

This is all set against a backdrop of a slumping pound and the continuing crisis in the banking sector, which is showing no sign of abating despite the Government's latest and second round of rescue aid.

Mr King and his US counterpart Ben Bernanke, chairman of the Federal Reserve, have both made clear in recent weeks that the bank woes must be resolved first before economies can recover.

Ironically, having got the economy into recession, banks are now being looked to for help in getting the UK out of it.

Even if lending can be kick-started, the path to recovery is looking rocky and potentially some way off, say experts.

Andrew Smith, KPMG chief economist, gave a sombre assessment of the economic prospects.

"The sudden deterioration puts official forecasts of a relatively shallow and short-lived downturn - the Pre-Budget Report pencilled in a recovery starting in the second half of this year - in serious doubt.

"Private forecasters are increasingly building in a recession at least as bad as the early 1990s, stretching into 2010."