Does the economy face a temporary period of stagnation or mild contraction to be followed by a recovery from the first half of 2009, or a full-scale recession of the sort experienced in the mid 1970s, early 1980s and early 1990s, involving a fall of several percentage points in GDP over a period of at least a year?. These notes have argued in favour of the former scenario for three main reasons: the interest-servicing burden on households has increased less sharply than before prior recessions; monetary growth has weakened to a lesser extent, at least to date; and the large fall in the sterling exchange rate over the past year should offer external support to UK activity.

Recent extraordinary financial events have clearly increased the risk of a full recession. In particular, financial turmoil may cause consumers and businesses to postpone spending decisions, possibly initiating a self-feeding economic downturn. However, the judgement here is that the less malign scenario remains the more likely, albeit involving a bumpier ride than previously envisaged. As explained further below, not all recent developments have been discouraging. The latest trade figures support optimism that net exports will cushion domestic demand weakness. Annual retail price inflation should fall precipitously over the next 12 months, providing a welcome boost to spending power. Meanwhile, financial events have created scope for the MPC to cut official rates earlier and by more than was previously likely without damaging its inflation-fighting credibility.

An improving trade account has provided major support to the US economy, with net exports contributing 1.7 percentage points to GDP growth of 2.2% in the year to the second quarter. The consensus has been sceptical of a comparable trade boost to UK activity, despite sterling’s plunge and the much higher shares of exports and imports in GDP. Independent forecasters expect net exports to contribute 0.4pp to GDP growth in calendar 2008 and 0.6pp in 2009, according to the Treasury’s monthly survey. Recent figures suggest a larger boost. Export volumes of goods excluding oil and erratic items were 3.6% above their 2007 average in June / July versus a rise of just 0.2% in imports. Suppose total real exports and imports, including services, grow at these rates for the year as a whole – plausible given that the full benefit of sterling depreciation has yet to be felt. Net trade would then add 0.9pp to calendar 2008 GDP expansion.

While the credit crisis is more often blamed, a squeeze on real income and money supply growth caused by this year’s surge in inflation has also contributed significantly to current economic weakness. The potential benefit from a likely reversal of this spike should therefore not be underestimated. The chart shows forecasts for annual CPI and RPI inflation through to the end of 2009 based on the following assumptions: 1) unprocessed food price inflation slows gradually from 13% in August to 2.5% by December 2009; 2) electricity / gas tariffs rise by a further 10% in September but energy prices are stable thereafter; 3) “core” CPI inflation – excluding unprocessed food and energy – slows gradually from recent rates, reflecting economic weakness and a fading impact from sterling’s decline; 4) the housing depreciation component of the RPI, which tracks house prices, falls by 15% by mid 2009, stabilising thereafter; and 5) Bank rate is cut by half a point to 4.5% by the end of 2008 (see below), remaining stable in 2009. On these assumptions, annual CPI inflation returns to the 2% target in September 2009 while RPI inflation falls below 2% in June next year, reaching 1.1% in September. Of course, further official rate cuts during 2009 would imply still-lower RPI numbers. While interest rate reductions contribute, falling house prices are the key reason for the forecast RPI / CPI divergence. The housing depreciation component carries a 5.5% weight in the RPI so the assumed 15% annual decline in mid 2009 subtracts 0.8 percentage points from the annual RPI increase.

Minutes of the September MPC meeting partially vindicate the recent dovish shift in the MPC-ometer model described in previous monthly notes. The vote changed from 1-7-1 in August (Besley seeking a 25bp hike, Blanchflower a 25bp cut) to 8-1 (Blanchflower voting for a 50bp cut). Taking into account the September outcome and available data on the other inputs, the model suggests a knife-edge October decision. Further weakness in consumer and business surveys released in late September and early October – plausible in light of recent financial events – would tip the balance in favour of a cut. Market developments will also be important. MPC members were concerned by the plunge in sterling during August but the effective index is currently 3% higher than at the time of the September meeting. Meanwhile, recent rises in unsecured interbank lending rates, unless rapidly reversed, threaten renewed upward pressure on household and corporate borrowing costs. As conventionally used, the MPC-ometer attempts to answer the question of whether a change in Bank rate is warranted by incoming economic and financial data. If the target is changed from Bank rate to three-month LIBOR, currently 6.1%, the model suggests a near-certain 25bp October cut and a further 50bp reduction by year-end, based on plausible assumptions about the inputs. Against these arguments, the MPC may feel itself constrained by a further rise in annual CPI inflation in September, possibly to 5% or above, as well as rapidly deteriorating fiscal prospects, which could undermine confidence in the wider macroeconomic policy framework. However, the disinflationary shock implied by recent financial events should allow the Committee to play down the former, while fiscal profligacy may affect the extent of the peak-to-trough decline in rates rather than the timing of the first cut.