Recession threat: Bank of England economist warns drastic action is needed

BRITAIN could follow America into a full-blown recession unless there is an urgent and aggressive cut in interest rates, a member of the Bank of England's monetary policy committee warned last night.

Economist David Blanchflower gave the ominous warning – including a prediction that house prices could fall by up to a third – after setting out the similarities between the UK and the US economies.

In a speech in Edinburgh, Professor Blanchflower said the UK was following the pattern that had led to recession in America and was set for a substantial decline in growth, a rise in unemployment, little real growth in wages and falling consumption driven by similar declines in house values.

Prof Blanchflower told his audience at the Royal Society of Edinburgh: "More bad news is on the way. I think it is very plausible that falling house prices will lead to a sharp drop in consumer spending.

"Developments in the UK are starting to look eerily similar to those in the United States six months ago.

"There has been no decoupling of the two economies: contagion is in the air. The US sneezed and the UK is rapidly catching a cold." And he said: "The credit crunch is starting to hit and hit hard."

Prof Blanchflower's speech will reinforce his reputation as the most "dove-ish" member of the MPC – he has voted twice for a 50 basis point cut in interest rates this year.

He told his audience that the Bank's recent injection of liquidity into the markets – known as the Special Liquidity Scheme – had been "an important first step forward" in avoiding recession. However, the part-time professor at Stirling university added: "Monetary policy in my view still remains restrictive currently, and we need to take action to loosen policy sooner rather than later.

"I do feel that the slower rates fall, the further they will eventually have to go down to boost the economy."

In a closely argued lecture, Prof Blanchflower set out his view that inflation was not the threat to the economy that many of his fellow MPC members seem to think it is.

The Bank has been set a target by the Chancellor – originally Gordon Brown now Alistair Darling – of keeping annual inflation at 2 per cent.

According to official Bank forecasts, the rate is set to rise above that in the short-term, which has led to some MPC members being more cautious on interest rate cuts for fear of stoking further inflation.

Prof Blanchflower said he was "not too worried about the recently reported increases" in inflation expectations. He told his audience: "I hope that it is clear that this is not me being complacent about inflation; I have been inaccurately referred to as a 'dove'."

He said he had simply not seen evidence of domestically driven medium-term inflationary pressures, particularly in the labour market. If he had seen those pressures, especially on wages he would have voted for increases in interest rates.

However, Prof Blanchflower said evidence from the housing market in particular led him to conclude that this was less of a threat and that a failure to cut more aggressively could lead to something "horrible" happening to the economy.

Part of his evidence included what he saw as "a correction of approximately one third in house prices", in other words a cut of that amount. That "does not seem implausible", he said.

The economist, who also teaches in America, has been consistent in voting for interest rate cuts on the MPC.

Speaking about his MPC role he explained: "Our main priority now is to ensure we conduct monetary policy in such a way that the UK doesn't slip into recession, causing us to significantly undershoot the inflation target. It isn't too late."

UP OR DOWN? THE NINE WHO DECIDE WHAT WE PAY

THE direction of homeowners' monthly mortgage bills largely lies in the hands of nine members of the Bank of England's monetary policy committee (MPC).

Set up by Gordon Brown when he was chancellor, it sets interest rates according to inflation targets handed down by the government.

Members include Mervyn King, governor of the Bank of England, who chairs the committee, the two deputy governors, the bank's chief economist, the executive director for markets and four external members appointed directly by the Chancellor.

American David Blanchflower, left, who joined the committee in 2006, flies in from the US for about 11 days a month at a cost of nearly £80,000 a year.

The MPC is split between "hawks", who tend to push for rate rises, and more cautious "doves".

Q & A: TRIALS AND TRIBULATIONS AT THE BANK OF ENGLAND

Why is David Blanchflower in favour of a further cut in interest rates?

He has argued that the two recent rate-cuts have not been passed on to borrowers because banks are eager to bolster their balance sheets.

He has also expressed fears that the UK could see the same degree of economic slowdown as the United States.

According to the minutes of the monetary policy committee, he had pressed for a half-point cut to 4.75 per cent, instead of the quarter point cut, to 5 per cent, which was agreed by the committee earlier this month.

Was it significant that the monetary policy committee was split?

Yes. The six-strong committee, headed by the Bank of England governor, Mervyn King, was split three ways for the first time in almost two years. The disclosure surprised many analysts, who had been forecasting a unanimous decision.

Why is the interest-rate level so important?

Policymakers are walking a tightrope between balancing the risks to the economy and a mandate to keep inflation pegged at 2 per cent.

Latest figures show Britain's economy is growing below trend, potentially giving the Bank more leeway to cut interest rates. However, some policymakers have insisted some slowing of the economy is necessary to curb inflationary pressures.

Recent signs of consumer resilience are adding pressure on the monetary policy committee to hold fire on aggressive interest-rate cuts.

The Bank is meant to keep the annual inflation rate close to 2 per cent – a target set by the government. But in February it rose to 2.5 per cent, from 2.2 per cent in January.

Where is further pressure on the Bank of England for interest rate cuts coming from?

The British Chambers of Commerce branded the most recent interest-rate cut "long overdue" and demanded another cut next month to 4.75 per cent. However Richard Lambert, director-general of the CBI, recently warned the Bank against risking runaway inflation by making big interest-rate cuts.

What other factors is the Bank wrestling with?

While lower interest rates are aimed at stimulating the economy by making it cheaper to borrow, they can make sterling a less attractive investment compared to other currencies where rates are higher – threatening other parts of the economy.

What other action has the Bank taken?

Earlier this month it launched a £50 billion intervention in the banking system to try to free-up the credit crunch.

It came as mortgage lending fell to a series of historic lows in recent months as high-street banks and building societies tightened their criteria for customers.