July 21, 2008 | posted by Michael Baxter in credit crunch, economic growth | comments (0) |

Of the various bodies out there who make economic forecasts, the ITEM Club from Ernst and Young is one of the best. Its proud boast is that it is the only independent consultancy which uses the same forecasting model as HM Treasury, so its quarterly reports deserve to be taken seriously. This morning its latest report was published.

“The UK economy is in danger of being crushed between the jaws of world credit and commodity markets, with little prospect of early relief,” began the report. It went on to talk about flirting with recession. Actually, though, a mere flirtation will be a real achievement when seen in the context of what is going on.

The ITEM club predicts growth of 1.5 per cent this year, followed by 1 per cent next. If it is right, and, frankly, the ITEM club has a good track record and it may well be right, then actually the UK will have done extraordinarily well.

The tough one, though, is this:

The ITEM Club says consumers are in denial.

It said: “… a tightening of credit and money market conditions. Domestic expenditure fell in the first quarter, but that was largely due to a fall in spending on inventories and investment. Households remained in denial, digging even deeper into savings to keep spending moving ahead in the face of rising tax, food and energy costs. The household saving ratio fell back from 3 per cent to just over 1 per cent.”

The report continued: “Mortgage equity withdrawal fell back to £5 billion in the first quarter (2.2 per cent of consumer spending), from £13.9 billion (6.6 per cent ) in the first quarter of last year, and ITEM expects it to fall further. With secured lending becoming less freely available, people are increasingly resorting to unsecured borrowing. This raised £1.4 billion in May, with credit card borrowing increasing by £0.6 billion, the largest figure for two years.”

But then the ITEM Club really rattled the optimists’ cage. It said: “Denial could turn to despair. Now, May is beginning to look like the last dance at the summer ball. Top retailers like John Lewis and Marks & Spencer have turned very negative. The worry is that without the required medication from the Bank of England, consumers will now move straight from denial into despair.”

Then ITEM club then rattled on about the Bank of England dilemma. About how it can’t reduce interest rates because of surging inflation, but needs to stop a nasty recession. In fact, the ITEM Club has predicted it will be another year before inflation falls back to less than 1 per cent above target.

Whether inflation takes off in the longer-term does depend entirely on what happens to wages. The threat of job losses is likely to curb wage demand in the private sector. But, as the ITEM Club warned: “This risk is most acute in the public sector, where pay increases have been held below those in the private sector and below the cost of living for nearly two years. Unison and other public sector unions want three-year pay deals to be reopened, but the government knows it cannot cave in on this one because that would mean base rate hikes which would cost it the election.”

It does, however, seem to us that while we all have sympathy with low paid workers struggling to make ends meet in the current environment, we are all too worried about our own jobs to be willing to give them much support. That is why union leaders are being asked by the media to justify their action in the light of the knock on effects it could have on the economy.

It wasn’t like that in the 1970s; back then, union demands for higher wages had much greater public support. So while inflation looks worrying right now, it is sure to fall quite a bit next year.

In this vein, ITEM Club said: “Price increases already in the pipeline will push CPI inflation to 4 per cent or more in the coming months, sustaining the letter-writing activity at the Bank of England. However, the big increases are almost entirely in food and energy prices. The core CPI inflation rate (which excludes the direct costs of food and fuel price increases) remains subdued at 1.6%. Providing that line can be held, inflation will drop back into line with the target over the next 18 months as commodity prices flatten out or fall back.

“The slowdown in the economy should help here, and a major collapse in world oil prices would bring a reduction somewhat sooner.”

For that reason, its expects cuts in the rate of interest this winter.

There is a danger implicit in cutting rates, however. And it’s a danger that even quite esteemed economic forecasters like the ITEM Club seem to overlook. This is a crisis born of too much consumer borrowing. We need, as was argued above, to save more. A cut in interest rates does smack a little of allowing consumers to borrow their way out of difficulty. And to quote James Callaghan, but slightly out of context: “I tell you, in all candour, this option no longer exists.”

If, on the other hand, rates fall, making existing debt cheaper, but credit remains tight and our borrowing is still restricted, this may be a good thing.

In short, a credit crunch coupled with low interest rates could be precisely what is needed to to end the real crisis, which is too much debt and the cost of repaying the debt.

We would still argue, however, that in the longer-term, the tax cuts outlined above would be even more effective.