Inflation and growth - two faces of the same problem

Over the last couple of weeks two distinct views seem to have developed regarding the UK economy's near term prospects. Each view highlights a danger. the first points to inflation, the second points to recession. However, both views miss something. The most probable outcome is both inflation, and recession.

The "inflation is the problem" view highlights the recent interest rate cuts as the primary danger facing the UK. The BoE have over-reacted to problems in the banking system and pushed out too much liquidity. The UK economy was already facing increasing inflationary pressure (mainly from food and fuel). Furthermore, throughout 2007 the UK economy was growing at quite a robust pace - in six out of the last seven quarters, the UK recorded 0.8 percent real growth, which adds up to rather perky annualized growth rate of about 3.3 percent. As such, there was little sign of any recession in recent GDP data that could have justified a looser monetary policy.

The "recession is the problem" view points to the spike in interbank interest rates, the collapsing housing market and the somewhat ambiguous retail sector data. This data points to a rapidly slowing economy in the near future, which requires an equally rapid monetary policy response. Lurking in the background is the possibility of a generalized banking crisis. The fear is that a rapid decline in housing would spark an increase in housing-related loan defaults, leading to deteriorating bank balance sheets. This view has certainly taken hold in the MPC who now seem certain to keep cutting rates during the first half of 2008.

However, both views can be easily reconciled. The fear of inflation is real. From 2005 onwards, the Bank of England did too little, too late to reduce inflationary pressures. Fuel and food inflation are definitely on an upswing. The Bank of England is also right to worry about the state of the UK Banking sector. Far too many banks have balance sheets that are in poor shape, and there remains a very real danger of other banks following Northern Rock. Likewise, the housing crash is now in full swing and it will tear into consumption expenditure with a vengeance. Growth is likely to slow very quickly.

Cutting rates probably won't generate another spurt of housing inflation. The banks are now much more wary of the property market. While headline mortgage rates might not go up, the volume of lending is definitely declining. House prices will crash, regardless of what the BoE does.

However, further rate cuts will probably generate quite a bit of inflation via the exchange rate. Declining interest rate differentials will push sterling down, and this will import inflation. Judging by the enormous current account deficit (currently at 5.7 percent of GDP), the pound is severely overvalued. A nominal correction is all but inevitable. While in the long run, a slowdown in GDP would exert downward pressure on prices, in the short run this effect is likely to be somewhat muted. In the short run, the exchange rate effect will dominate.

Looking foward, the Bank of England are stuck in a hole. Cutting rates won't prevent a recession or protect property values, while raising rates would exacerbate problems in the banking sector. So inflation, recession, banking problems, and a housing crash - that is what is waiting for the UK economy as it rings in the new year.