IS THERE ANYTHING THE UK CAN DO TO AVOID RECESSION?

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With all the press coverage lately - how likely is a recession?

The UK economy is now in danger of being crushed between the jaws of world credit and commodity markets, with little prospect of early relief.

The credit markets for banks and companies remain frozen and the mortgage market has moved from feast to famine over the past year.

Oil prices, which the Treasury were assuming would be $83 a barrel at the time of the Budget in March, have been testing $150 recently. Food and energy costs are set to push consumer price inflation above 4%, making a wage-price spiral a very real possibility.

The Bank of England's Monetary Policy Committee simply cannot cut interest rates while this risk remains. The chancellor is certainly in no position to rescue us from this fate, despite the extra tax he is getting from North Sea oil producers.

Housing collapse

 
Unfortunately, the housing crisis is mutating and spreading.

What started as an interruption in the supply of credit has turned into a general collapse as purchasers put their plans on hold in the expectation of much lower prices.

In the construction sector, the CIPS purchasing managers index plunged to 38% in June, the lowest since this survey started in 1994. The all-important service sector survey balance fell back to 47.1% as these problems spread.

More of a surprise - in view of the prospects for exports - was that the balance for manufacturing fell by nearly 4 points to 45.8%, lower than at any time since 2001.

Economic horror movie

Consumers have been in denial, maintaining the momentum in spending by resorting to unsecured borrowing. This raised £1.4bn in May, with credit card borrowing increasing by £0.6bn, the largest figure for two years.

However, May is beginning to look like the last dance at the summer ball. Top retailers like John Lewis and Marks and Spencer have turned very negative.

The worry is that without the usual medication from the Bank of England, consumers will now move straight from denial into despair.

As with any horror movie, there is an escape route but it is not an easy one.

Discipline

  An outbreak of wage inflation would spell disaster
 
Wage increases must remain restrained despite the tremendous pressure from food and energy cost inflation.

An outbreak of wage inflation would spell disaster, requiring much higher interest rates and a recession in output to get inflation back under control. This risk is most acute in the public sector, where wages have been held below the private sector and the cost of living for nearly two years now.

Fortunately, the government know that they cannot cave in on this one, because that would cost them the election. Collective bargaining is less important in the private sector, where employees are subject to the market disciplines that their employers face.

House prices 'to fall 15%'  


The construction sector is shrinking sharply
In view of this, the Item forecast assumes that wage and domestic cost inflation remains subdued, keeping the core CPI inflation rate (which excludes fuel and food cost increases) close to its current rate of 1.6%.

Providing that line can be held, inflation will drop back into line with the target as commodity prices flatten out or fall back. Retailers are absorbing many import cost hikes in margin and supply chain economies and that will continue as consumer demand weakens.

The pressure on household incomes is set to intensify over the rest of this year, particularly at the lower end of the income scale. Falling house and equity prices will be a negative factor for the better off.

The forecast sees a peak to trough fall of 15% in house prices.

Profit crunch

Rising commodity prices also depress company profits. It is hard to see many employers taking on new staff in this depressed environment, while large numbers of jobs are being lost in the financial services, construction and retail sectors.

Immigration is likely to slow down and possibly reverse as employment prospects deteriorate - indeed there are already signs of that happening - helping to reduce the impact of job losses on the unemployment figures.

Nevertheless we expect unemployment (on the ILO's labour force survey measure) to increase from the low point of 1.6 million reached at the end of last year, topping the 2 million mark in time for the election in 2010.

Flirting with recession

It is hard to see the consumer defying gravity for much longer against that bleak background.

We expect a slowdown in the High Street to pave the way for a rate cut this winter.

Provided that wages remain restrained, the Bank of England will then be able to shore-up the economy next year with further rate reductions.

Yet even on that relatively optimistic view, the forecast still shows growth falling back from 1.5% this year to 1% in 2009 as the economy flirts with recession. CPI inflation remains above the target range of 1-3% until next autumn.

This would be the worst outcome since the early 1990s - on both counts.

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