OECD takes a sideswipe at both Brown and the Bank

Economic think-tank attacks Chancellor's public spending plans and surprise rate cut

Doubts over the wisdom of February's surprise interest rate cut by the Bank of England resurfaced yesterday after a leading global economic think-tank launched a veiled attack on the move and took a sideswipe at the Chancellor, Gordon Brown.

The Organisation for Economic Co-operation and Development (OECD) said the Bank had loosened monetary policy "despite the persistent vigour of house price inflation".

The organisation cautioned against further rate cuts, hiking its inflation forecasts for both this year and 2004. "With growth more resilient and fiscal policy more stimulative than in the euro area, there seems to be much less need for further cuts," it said.

The OECD also criticised the Government's public spending plans, joining a chorus of critics saying taxes must rise eventually to fill a black hole in the public finances.

The assessment of the UK economy by the OECD is considerably more glowing than many other major countries, and especially the eurozone.

"The UK economy has so far shown greater resilience in weathering the downturn than other major European economies," the organisation said in its annual economic outlook.

"An expansionary fiscal stance and a reduced drag from net exports should ensure a slight pick-up in growth this year, despite a slowdown in consumption."

The OECD's economic forecasts were more optimistic than other institutions such as the International Monetary Fund (IMF), forecasting 2.1 per cent this year (down slightly from 2.2 per cent) and 2.6 per cent in 2004 (up from 2.5 per cent).

But the revisions to inflation were more dramatic. It expects inflation to average 3.1 per cent this year and decline to 2.8 per cent next year.

This means inflation will be above the Government's 2.5 per cent target for most of the two-year horizon that the Bank has tended to examine when setting interest rates.

Michael Saunders, European economist at Citigroup who believes rates should stay on hold, said: "The OECD has become significantly more worried about upside inflation risks for the UK."

This contrasts will the latest forecast from the Bank, published in February, which shows inflation falling steadily towards the 2.5 per cent during 2004 on a trajectory that would leave it below target by early 2005.

The OECD's view also contrasts with the IMF, which earlier this month said it believed that there was scope for "additional monetary policy easing".

For its part, the OECD said: "The recent easing of monetary policy, while justified by signs of weakening domestic and international demand, may fuel the housing market.

"And it does nothing to reduce the risk of a sudden fall in house price inflation or even possibly an abrupt fall in the level of house prices."

The housing market has become a dilemma for the Bank. Its continued strength in the midst of a downturn has helped sustain general economic growth.

But the higher prices rise, the faster the increase in borrowing either to buy a home or cash in some of the wealth, making an eventual fall in prices more damaging for the economy.

The OECD sees the latter as a real risk. "A fall in the level of house prices, which in relation to average earnings are close to the peak reached in the late 1980s, could lead to a sharp retrenchment of consumers' expenditure," it says.

But it acknowledged there were signs that the market is starting to soften, especially in London and property hot spots in the South-east where prices are falling.

The Royal Institution of Chartered Surveyors reports prices falling at the fastest pace for eight years while demand for mortgages for house purchase appears to be falling.

For some economists, such as Colin Warren of the independent analysts GFC Economics, this clears the way for another interest rate cut. "These developments undermine the view that the housing market bubble is unlikely to deflate in the absence of higher rates," Mr Warren said. "'A mere change in sentiment is all that has been needed for prices to fall back."

While the Chancellor will be delighted with the positive growth forecasts in the OECD report, he will be less happy with the think-tank's warning on the public finances.

The OECD said that Mr Brown's "golden rule" – where he only borrows to invest over the economic cycle – should be met for now but "that there will be a greater challenge in meeting it over the next cycle".

This echoes warnings from the Institute for Fiscal Studies, the National Institute for Economic and Social Research and the accountants PricewaterhouseCoopers that tax rises of up to £20bn will be needed to balance the budget in the medium term.

The OECD shares their concerns that the revival in corporate tax revenues, which declined 9 per cent in the financial year just ended, might not revive.

But the domestic picture is still overshadowed by what the OECD described as the "unspectacular" recovery of the world economy. It warned the world was in danger of tumbling back into recession. Growth in the economies of its 30 member nations, which includes the UK, would average just 1.9 per cent this year.

This is below the 2 per cent mark that many economists commonly say is tantamount to a global recession.

The OECD's chief economist, Jean-Philippe Cotis, said: "Worries about oil prices, anxiety in the face of war, fear of terrorism and epidemics, loss of confidence in international governance – the list of the so-called geopolitical and psychological factors is long."

Mr Cotis said he could not rule out a "relapse into recession" although he said it had a low probability.

The think-tank recommended the European Central Bank cut its interest rate a half-point – and "the sooner the better" according to Mr Cotis.

It slashed its growth forecasts to 1.0 and 2.4 per cent this year and next, from its early estimates of 1.8 and 2.7 per cent respectively.

The United States is forecast to grow 2.5 per cent this year, and 4.0 per cent in 2004, but the OECD said risks to the recovery came from the global geopolitical situation and consumer confidence.

Consumer confidence in the three main economic areas – the US, the eurozone and Japan – have slumped with the sharp falls in their stock markets since the dot.com bubble burst at the beginning of 2000.

This factor and the consequent overhang of excess investment – rather than the uncertainty over Iraq or the deadly Sars (severe acute respiratory syndrome) virus – is the main drag on economic growth.

The risk for the UK is that, even if it copes with the housing market bubble, it might find that investment activity in the rest of the world fails to rebound in time.