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The economic forecasting group says that the risks of an outright domestic recession remain low given the momentum in growth, the strength of the world economy outside the US and the recent and prospective easing in monetary policy.

Peter Spencer, chief economic advisor to the Ernst & Young ITEM Club, said that 2008 is going to be a year of adjustment.

“We are facing serious problems as a nation of borrowers, particularly the Chancellor. It is important, however, to put these into perspective,” Spencer added.

He points out that the economy is fundamentally sound, the problems in the inter-bank market seem to be resolving themselves, employment is high and inflation under control despite the inflationary threats from world commodity and currency markets.

Interest rates must come down

The abrupt reversal in the credit markets in 2007 will lead to a fall in economic growth, but ITEM believes that there is room for interest rates to be cut to cushion this.

ITEM expects that the Bank of England will cut rates by a quarter of a point at least three times this year. The group says that business remains in good shape and is in a position to pick up the baton from the consumer.

“Manufacturing – or what is left of it after ten years of living with an overvalued currency – is set to benefit from a lower exchange rate and the expansion of overseas markets,” ITEM adds.

ITEM forecasts manufacturing output to grow by 1.4 per cent in 2008 and 2.5 per cent in 2009 after flirting with recession for years.

The rise and rise of sovereign wealth funds

One of the main reasons for relative optimism in the global and UK economic outlook is the recent activity of the Sovereign Wealth Funds (SWFs), which are replacing some of the capital destroyed by the credit crunch.

Every week brings more multi-billion dollar investments that are helping many of the financial institutions which have been seriously hit by debt write-offs to prop up their balance sheets.

Spencer says that funds controlled by authorities in China, Singapore, Dubai, Qatar and Abu Dhabi have been writing large cheques and find themselves as very large investors in Western financial companies.

He adds, however, that this is no cure-all panacea for the credit crunch even if it brings some very welcome immediate relief.

“The SWFs may have trillions at their disposal, but are the banks’ shareholders (and the US government) going to continue to allow investment on these often punishing terms once this phase of the credit crunch passes? Even if they do, that will push up the banks’ cost of capital and ultimately corporate and individual borrowing costs,” he warns.

The public finances are in a mess

With the prospect of slower growth this year and hence slower tax revenues, ITEM forecasts a grim outlook for the public finances.

The current deficit over the first eight months of the financial year came in at £23.1 billion - £8.6 billion worse than last year. Net borrowing was £36.2 billion, £10.2 billion worse.

Spencer predicts that the public finances will deteriorate rapidly now that the economy is slowing sharply.

ITEM has revised its forecast of this year's current deficit up to £14 billion, compared with the Treasury PBR forecast of £8 billion. Spencer says that this assumes that public expenditure is in line with the Treasury's very tight plans, which is likely to prove optimistic in current circumstances.

“The Treasury failed to take advantage of years of good growth to put our public finances on a sounder basis, so our ability to respond by easing fiscal policy has been compromised,” Spencer says.

“The Government should have begun to sort out the national finances three or four years ago. Brown’s famous self-imposed 'golden rule' was meant to stop us getting into this kind of bind but I’m afraid it will now make matters worse,” he adds.

British households feeling the pinch

Households' finances will be much more focused on savings with consumption growth expected to slow in 2008, according to ITEM.

The deceleration should be cushioned by a strong labour market, however, and loosening monetary policy. ITEM forecasts household expenditure to grow 2.0 per cent this year, strengthening slightly to 2.2 per cent in 2009.

Spencer says that Britain has been living beyond its means, lured by the offers of cheap no-questions-asked credit and tempted by the high prices that the family silver will fetch in international markets.

“In the future, most families have no option but to tighten their belts. They can no longer afford to dip into housing equity to keep up the growth in spending," he adds.

Appropriate policy response 

There are several major risks to economic stability in 2008, starting with the US economy, the credit crunch and sterling depreciation.

Another risk is that policy-makers make more mistakes in responding to this tricky situation. ITEM assumes that we get the appropriate policy response. It says that if this is not the case, all bets are off.

Spencer concludes that the economy is in good health and that employment levels are at their highest ever. As the Bank of England's interest rate cuts begin to take effect, he expects that the economy should pick up.

“With the money markets begin to thaw out we can be a bit more optimistic. So, touching wood, 2008 should not be such a bad year after all. Then I expect GDP growth to move back up to 2.5 per cent in 2009,” according to Spencer.

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Related links

• Ernst & Young ITEM Club