King paints bleak picture of UK economic outlook

October 22, 2008

The Governor of the Bank of England, Mervyn King, has for the first time conceded that the economy is "likely" to slide into recession this year. Mr King has previously studiously avoided uttering the "R-word", but he told business leaders in Leeds last night that "it now seems likely that the UK economy is entering a recession."

Mr King said that "not since the beginning of the First World War has the banking system come so close to collapse" and that the supply of finance to the British companies has "ground to a halt".

Although Mr King saw hopeful signs of easing in the credit markets, with credit default premia declining and Libor spreads also calming, the IMF warned that Europe's banking system remains stressed. The fund said that more European banks may fail as cash injections dry up and the region's economy grinds to a near-halt next year. In the US, the Federal Reserve said yesterday that it would finance up to $540bn (£320bn) in purchases of short-term debt from troubled money market mutual funds. The Fed will lend money to five special-purpose vehicles, to be run by JPMorgan Chase, as part of its continuing efforts to stabilise the financial system.

Ahead of the release of official figures on Friday – widely assumed to confirm that the UK economy contracted during the third quarter of this year – the National Institute for Economic and Social Research (NIESR) also predicted that the economy would shrink during 2009, and the CBI reported the worst set of business confidence readings among industrialists since 1980.

The admission from the Bank of England that recession is likely is significant. As recently as when the Bank's last Inflation Report was published in August, the Governor maintained that economic activity would be "broadly flat" over the next year. Mr King then dismissed the media's apparent obsession with the possibility of a recession. "I think the important question is not whether or not there is a quarter or two of negative growth... but whether we can maintain the broadly flat path of output or whether there is the downside risk materialising of a more severe downturn."

Pressure is growing on the Chancellor to radically downgrade his own growth forecasts when he delivers his pre-Budget report in the next few weeks. Mr King's more pessimistic view may also mean a more aggressive programme of interest rate cuts by the Bank. Some observers see them falling to as low as 2 per cent next year, equal to their record low during the Bank's 314-year history.

The UK economy last contracted in the second quarter of 1992. It recorded zero growth in the second quarter of this year. The conventional definition of a recession is two successive quarters of "negative growth".

The CBI's latest Industrial Trends survey suggests even the weak pound – devalued by about 12 per cent since the summer of 2007 – is failing to be much help to beleaguered manufacturers. Orders are falling at their fastest rate since 1999, and manufacturers report their sharpest quarterly fall in output since 1980 – which was by far the deepest recession since the Second World War and a time of steeply rising unemployment.

Domestic demand and export orders both fell during the July-to-September period, says the CBI. Some 16 per cent of firms reported difficulty in obtaining finance as a constraint on their activities – clear evidence that the credit crunch has reached far beyond housing and the banks.

Although manufacturing now accounts for only 15 per cent of the British economy, the scale of the contraction in the sector and its implications for the wider economy shocked some analysts. Howard Archer, UK economist at Global Insight, said: "The CBI survey is quite simply terrible. Extreme weakness is evident across the board."

Three large motor manufacturers – Nissan, Land Rover and Ford – have announced short-time working in recent weeks, and further cuts to output in other sectors seem certain to follow.

More broadly, the NIESR said the economy would decline by 0.9 per cent during 2009, and the UK would endure an 18-month period with either negative or nil growth. The institute said "the British economy will suffer next year as it experiences the worst setback among the G7 countries", with an especially large reduction in consumer spending forecast – down 3.4 per cent. Business and housing investment are also set to decline, and unemployment will hit the 2-million mark before the end of this year: "The UK is especially vulnerable to the credit crisis because of imbalances that had developed in recent years... Household debt rose to 170 per cent of income by the end of 2007".

Martin Weale, the director of the NIESR said: "The Government, when it came to power in 1997, adopted a monetary and fiscal framework which was intended to deliver low and stable inflation, high and stable economic growth and fiscal balance as a basis for fairness between generations. It is abundantly clear from the chaos of the past few weeks that the policy has failed".

The NIESR predicts global growth of 2.8 per cent next year. The US, it says, will decline by 0.5 per cent and the eurozone will grow by 1.1 per cent. The downbeat view of European prospects was echoed by the IMF, which said recapitalisation of European banks was "now likely to slow". Even so, a full-blown banking crisis in Europe is "improbable".

The property market, meanwhile, remains in the doldrums. HM Revenue and Customs reported 61,000 residential properties changed hands in September, less than half the number sold in the same month last year. This decline will continue to have a depressing effect on spending and growth, economists agree.