UK slides into recession

Today's GDP data release was shocking. The UK economy shrank by 0.5 percent in the third quarter, giving an annualized decline of 2 percent. Given that economic growth in the second quarter was flat, we are on fairly safe ground claiming that the UK is in a recession.

As the grim news spread across the media, we heard the usual predictions that the Bank of England would now cut rates. At its next meeting, the MPC will offer a hefty headline grabbing rate cut. A fifty basis points cut is definitely on the cards. Who knows; the MPC might even go further.

Predicting the MPC's response is easy, predicting the response of the economy to lower rates is much harder. My sense is that in the short run, cutting rates will not rescue the economy from a deep recession. In the long run, it is likely to do more harm than good.

A rate cut will not work because the credit crunch has wrecked the monetary policy transmission mechanism. Under normal circumstances, if the MPC was a little worried about growth, it could cut its official rate. Interbank rates would follow, and since the loan rate are mosly priced in terms of LIBOR, credit would bcome cheaper. Firms and households would borrow more, demand would pick up and economic growth would increase.

Monetary policy does not work like this anymore. The MPC have already cut 100 basis points off its official rates, and lending rates have, for the most part, have not responded. Moreover, published interest rates do not tell the full story, credit availability has tightened, particularly for mortgages and home equity loans.

However, there is a deeper inconsistency at work here. Banks are cutting back on loans because they now recognise that the UK household sector is overloaded with debt. If a couple of additional rate cuts actually encouraged further credit growth, it would only lead to a further deteroriation of household balance sheets. This would imply higher risk levels for banks, which can only be compensated by higher lending rates. Fundamentally, this is the reason why previous rate cuts haven't worked so.

What about inflation? Won't a slowdown solve this problem, leaving monetary policy to focus on demand management? If the past is any guide, inflation can be surprisingly persistent, even during deep and nasty recessions.

When the economy slip into recessions, it undergoes some very unpleasant structural changes, which often reduces aggregate supply. As firms disappear, supplier relationships are disrupted, and this adds to costs. As competitors disappear, the remaining firms gain a degree of monpoly power that allows them to push up prices. When firms downsize, they lose valuable human capital that makes firms as a whole less productive. As the economy's supply capacity contracts, prices tend to go up. It is worth recalling that in the three previous recessions, inflation remained supprisingly high.

In addition, rate cut might exacerbate these trends by weakening sterling and raising import prices. So the UK may end up with a rather nasty combination of negative growth and rapid inflation.

Certaintly, the data so far confirms this unpleasant scenario. As I have pointed out many times before, the UK inflation rate picked up very sharply as the credit crunch first hit our financial markets.