Inflation and interest rates will both stay close to zero, benefiting those on tracker mortgages and pensioners, but giving very little assistance to a beleaguered housing market which ITEM believes has a further 22% to fall over the next 18 months.
However, ITEM believes that the Government’s actions since September have been constructive and helpful and without them the situation that the UK economy is now facing would have been far worse. Brown and Darling have to think boldly and creatively and then with a fair wind the UK economy will emerge from this recession rebalanced and ultimately more robust.
Peter Spencer, Chief Economic Advisor to the Ernst & Young ITEM Club, said: “It is easy to criticise and conclude that none of the Government’s policies are working. However, we must not lose sight of the fact that they have prevented the collapse of the monetary system as we know it. But, more needs to be done urgently otherwise the flow of credit will remain frozen and the economy will remain in recession.”
The banking system in the UK and around the world remains in a parlous state with banks unable to lend to companies and consumers because of their worries about loan losses and the need to back loans with new capital and honour credit lines to secondary banks.
Spencer said: "Ultimately the unfreezing of the global and hence the UK banking system requires the US to resolve their domestic banking problems. This is because most of the world’s surplus savings – in particular, central bank funds and petrodollars – are recycled to borrowers through dollar markets. UK market rates will remain a premium to the base rate as long as dollar rates remain at a premium to the Fed’s zero-interest rate. Credit will stay very tight in the UK until the US inter-bank markets spark back into life and all of these premia shrink back to normal levels.”
With a stuttering banking system and the UK economy heading for a deep recession, business sentiment will continue to deteriorate. ITEM expects business investment to fall by nearly 16% in 2009, with a further drop of almost 6% in 2010. Spencer said: "Precautionary behaviour has begun to spread with corporates planning for the worst. Investment intentions and recruitment plans have collapsed. Company treasurers are very worried about what lies around the corner in 2009 and prefer to be sitting on cash."
ITEM predicts that consumer spending will decline by 2.6% in 2009 followed by a further fall of 0.6% in 2010. This is consistent with a rise in the savings ratio to 5.5% by the end of 2010, but there is a significant risk of a deeper consumer retrenchment. For the first time in a generation it will be the fear of being out of the work that drives consumer behaviour. And with good reason as ITEM forecasts that unemployment will reach 3.4 million in 2011.
Spencer said: “In this harsh climate, people will be very worried about job security. The workforce is directly in the firing line, making consumers much more cautious in their behaviour this year. Earnings growth will subside, reinforcing the pressure on disposable income. We see average earnings growth falling below 2% in 2009. Some relief will be provided by inflation, which is set to fall below the 1% CPI threshold next summer, but real disposable incomes are set to fall by 0.4% in 2009, and to recover by just 1.1% in 2010.”
The forecast predicts that house prices have further to fall and forecasts a 16% fall in house prices over 2009 and a further 6% in 2010, with a peak-to-trough decline of more than 33%.
Spencer said: “The housing market remains in dire straits, starved of new mortgage finance. Net lending will remain at negligible levels until overseas mortgage–backed loans are repaid. Although bargain hunters are active, there seems very little reason to buy until house prices stop falling. We do not see that happening until the end of 2010.”
ITEM is calling for a more aggressive monetary policy. The MPC needs to push base rates towards the zero bound, without fretting unduly about the pound. Like the US, the UK may head towards Japanese style policies – the zero interest rate policy, or ZIRP, may well have to be deployed for the worst case scenario.
Spencer said: “Quantitative monetary policy techniques should be adopted immediately, without waiting for lower interest rates. That would mean government purchases of gilts, mortgage-backed or other securities, pushing down their running yields and effectively replacing them in private portfolios by notes and coin or bank deposits with the Bank of England, which form the monetary ‘base’. The aim would be to supply any cash that people want to hold – and some – in the hope that these surplus funds would be spent or invested.”
ITEM expects world trade to fall by 2% this year, while exports are likely to fall back by 1.5%. Nevertheless, with sterling at these very competitive levels, UK exporters are in pole position for the recovery ITEM anticipates in international trade next year with exports increasing by 4% in 2010 and 6.5% the following year.
Spencer said: “The unprecedented fall in the pound presents many businesses with heaven-sent opportunities to switch production away from the home market and ultimately to develop new outlets and products. Furthermore, large multinational companies that can access the necessary finance will surely boost their capital expenditure programmes to expand UK manufacturing base in anticipation of a recovery in the world economy.”
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