Uk Recession?

Bank Woes May Tip Uk Into Recession

By Roger Bootle, Telegraph.UK | 11 December 2007

Will the Bank of England (BoE) do enough to avoid recession? A week is a long time in economics. At the start of last week it looked unlikely that interest rates would be cut but by Thursday the reduction of 0.25pc was no surprise at all. So how did things change so quickly?

By Thursday morning the pressure on the Bank had become intense. First, two distinguished previous Monetary Policy Committee (MPC) members urged the Committee to act. Professor Willem Buiter said that if the MPC did not cut rates it would be "wimpish". Meanwhile, Dr Sushil Wadhwani said that leaving rates on hold would mean that the MPC was in danger of returning to the "bad old days" of backward-looking monetary policy.

Second, the liquidity problem in the banking system was intensifying.

Third, the Bank of England was under pressure from the actions of other central banks. The US Federal Reserve had already slashed rates by 0.75pc, with another 0.25pc likely this week. And last Tuesday the Bank of Canada cut interest rates by 0.25pc.

Finally, the weaker run of economic data, and the strident tone of most newspaper commentaries, meant that come the day of the big decision the markets were more or less fully expecting a cut. If the Bank had not acted there would have been consternation.

After the intense criticism over its handling of the Northern Rock affair, both here at home and abroad, the Bank was in a weak position to resist such pressure. In particular, because of Northern Rock, the Governor, Mervyn King, has seen his own personal position weaken considerably. It will be fascinating to see, when the minutes are released on 19th December, whether the Governor voted for this cut or not. I suspect that he did.

So the Bank is open to the criticism that it has merely buckled under pressure. But I don't think that this charge will stick. A rate reduction last week was justified, not least by the consistently weak tone of recent economic news. In particular, Halifax reported that in November house prices fell by 1.1pc, the third successive fall, meaning that prices have already fallen by 2.4pc since the end of August. This compares with the total fall in prices of only 0.7pc in the 2004/05 housing market slowdown.

And there was also evidence of a weakening in the wider economy. The headline balance of the CIPS/RBS survey on the services sector fell to a four-year-low in November.

Furthermore, conditions in financial markets have become very worrying, with interbank rates remaining almost 1pc above bank rate, thereby resulting in an unintended extra tightening of monetary conditions. Last week's cut will still leave three-month interbank interest rates well above the levels seen immediately after the last rate hike in July.

So where do we go from here? There are good reasons to think that more action will be needed, including the precarious state of the housing market and the threat of a much weaker international environment.

But won't substantial interest rate cuts risk setting off inflationary pressures? Of course, there are such risks and if they look like becoming more serious then the MPC will not be able to cut rates so vigorously. Much depends upon the strength of the forces pulling towards an economic slowdown. A weaker economy should tend to reduce inflation. Moreover, if, as seems likely, this weakness is mirrored internationally, then there is a good chance that oil and food prices, which have heightened inflation fears, would subside.

Could all this be too dramatic? Yes, is the answer. The economy could prove stronger than I am forecasting. Liquidity may return and confidence recover. The housing market may respond favourably to this interest rate cut and another couple to come next year. Lower oil prices could inject spending power into western economies and simultaneously reduce inflation. All of this could mean that we experience only a mild and short-lived slowdown which does not require drastic interest rate action from the Bank.

But although this is perfectly plausible I do not think that it is likely. What worries me most is what is happening in the banking sector. We have grown complacent about financial sector upsets because previous versions involved big drops in equity prices. By contrast this one involves heavy pressure on the banks and the drying up of credit. I cannot recall when we in Britain last experienced a credit crunch. Examples from abroad offer no encouragement. Japan is the most striking case where the bursting of an asset bubble left the banking system weighed down by bad debts and collapsed asset values and thereby enfeebled in its ability to make new lending.

Our situation is not as serious as Japan's was then but there are some worrying parallels. This is not just a UK problem. The exuberance of Anglo-Saxon financial systems has sustained not just the Anglo-Saxon economies themselves but the world as a whole. Credit has been what has kept us afloat. So the current difficulties strike at the very heart of our economy.

Why are banks so reluctant to lend to each other? This could be simply an unjustified panic and a self-fulfilling prophecy where, because each fears that liquidity has dried up, each is not prepared to put money in the markets, thereby creating collectively the very thing which each individual bank fears.

But it is also possible that the banks' reluctance to lend reflects a rational fear that bank losses are already, and will be in the future, much bigger than the manageable estimates of losses from sub-prime mortgages suggest. I think this is probably closer to the mark. Over and above the sub-prime losses, there will be losses from prime mortgages and from lending to commercial property, and from heaven knows what else— in both the UK and in the US. There are the makings here of a nasty interaction between weak asset prices, bank losses and a weak economy.

So why will recession be avoided? It may not be. But the contrast with the conditions which led to previous UK recessions is significant. In the recession of the mid 1970s, late 1970s and early 1990s, inflation was a serious problem— on a scale which knocks today's worries into a cocked hat. And in 1990-92, the key difference to today is that we were then in the ERM so that when the economy started to weaken and inflation looked to be under control we still could not cut interest rates [[The coming world recession (2009) will be a severe test for the EU.: normxxx]].

This time, by contrast, the MPC will be able to cut vigorously if the need arises— as I suspect it will. I now expect UK interest rates to fall to around 4.5pc by the end of next year. What's more, if the economy remains weak in 2009, then interest rates could fall further to 4pc.
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Normxxx    
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