We expect evidence that the economic downturn is deepening, coupled with the heightened risk of a prolonged significant recession stemming from the serious financial sector problems and very tight credit conditions, to push the Bank of England's Monetary Policy Committee (MPC) into cutting interest rates on Thursday, despite the fact that inflation is currently still rising. We expect interest rates to be cut by 25 basis points from 5.00% to 4.75%. We would not rule out a 50-basis-point cut to 4.50%, given that very tight credit conditions mean that a 25-basis-point cut is likely to have only a very limited impact.

Although only David Blanchflower favoured an immediate interest rate cut at the September MPC meeting (and a 50-basis-point one at that), the economic environment and outlook has darkened substantially since then. Recent speeches by two MPC members, Sir John Gieve and Kate Barker, indicated that they are becoming increasingly concerned about the downside risks to the economy and believe that consumer price inflation could undershoot its 2.0% target rate in the medium term. This suggests that they are inclined to cut interest rates sooner rather than later, and the situation has deteriorated further since they made their speeches.  Admittedly, Andrew Sentance's latest remarks suggested that he remains in no hurry to cut interest rates given still-significant inflationary pressures. Sentance is seen as among the most hawkish members of the MPC; and, again, the economic situation has deteriorated significantly since he made his speech.

The MPC have long regarded tight credit conditions as a particularly serious risk to economic activity through weighing down on the consumer, business investment, and house prices. Therefore, the further marked tightening of credit conditions and higher market interest rates that are resulting from the current heightened financial sector problems will be of major concern to the Bank of England; particularly as it is occurring at a time when the economy already seems to be headed for recession.

Indeed, latest data and survey evidence have been very worrying overall and strongly suggest that the economy contracted in the third quarter. In particular, the purchasing managers' surveys for the service sector, manufacturing and construction sectors all showed significant contraction in September. Indeed, the survey for the dominant services sector pointed to the sharpest decline in activity since the survey began in mid-1996.  Consequently, our weighted-composite index for the purchasing managers' surveys for the service sector, manufacturing, and construction sectors sank to 44.7 in September, and averaged just 46.3 in the third quarter compared to 48.7 in the second quarter when the economy only stagnated.

Encouragingly for the Bank of England, there are signs that underlying inflationary pressures are starting to ease even though headline consumer price inflation climbed to 4.7% in August (significantly more than double the Bank of England's 2.0% target) and could well reach 5.0% in the near term due to higher utility prices. Producer prices retreated in August, while the prices charged indices in the September purchasing managers' surveys weakened. This suggests that sharply weakening demand and activity is starting to dilute companies' pricing power. In addition, the recent sharp fall in oil and commodity prices should help to reduce companies' costs, thereby easing the pressure on them to try and raise their prices. Meanwhile, the evidence largely points to wage moderation continuing.

Admittedly, it is premature to sound the all-clear on inflation. In particular, inflation expectations remain elevated and there is still a risk that this could yet lead to wage settlements moving higher. In addition, the marked retreat in sterling is likely to push up import prices.

Nevertheless, we expect interest rates to be cut by 25 basis points from 5.00% to 4.75% on Thursday, and would not rule out a 50-basis-point cut to 4.50%. Further out, we now expect interest rates to come down to 3.25% in 2009. This reflects our expectation that GDP will contract by 0.3% in 2009.

MAIN ECONOMIC RELEASES

Manufacturing output (out Tuesday) is expected to have fallen 0.2% month-on-month in August, as it did in July. This would mark a sixth successive decline. Consequently, output is projected to have fallen 1.6% year-on-year in August. Industrial production is seen falling 0.1% month-on-month in August, after sinking 0.4% in July. The overall fall in industrial production is expected to be limited by oil and gas extraction picking up having been limited in July by routine maintenance work in the North Sea. Nevertheless, industrial production is still seen down 1.9% year-on-year in August.

There seems little doubt that manufacturing output contracted again in the third quarter, after plunging 0.9% quarter-on-quarter in the second quarter, thereby putting the sector in recession. Manufacturers are being hit hard by muted domestic demand, weakening activity in key export markets, elevated energy and commodity prices, and tight credit conditions. While the significantly weaker pound is helping U.K. manufacturers, this is being countered by weak domestic demand in key export markets, notably the Eurozone and the United States.

The Nationwide lenders' consumer confidenceindex (out Wednesday) is forecast to show that sentiment weakened markedly in September, to be at its lowest level since the survey was first published in May 2004. Specifically, we project the Nationwide's consumer confidence index to have retreated to 49 in September from 52 in August and July and 63 in June. We expect already very weak and fragile consumer confidence to have taken a substantial hit from the heightened financial sector crisis and growing fears of a prolonged, deep downturn.

The trade deficit (out Thursday) is expected to have narrowed very modestly in August. While U.K. exporters are benefiting from the markedly weaker pound, this is being countered by softening domestic demand in key foreign markets. In particular, the Eurozone is now in serious danger of falling into recession, while U.S. domestic demand is weak. Nevertheless, net trade is likely to benefit from U.K. imports being limited by significantly softer domestic demand over the coming months. Of interest to the Bank of England will be what happened to import prices in August. The sharp retreat in oil prices from their July peak of US$147/barrel and lower commodity prices should start to be reflected in the data, but this will be countered by the upward impact on input prices from the weaker pound.  

As a consequence of very weak housing market activity, stretched affordability, and very tight lending conditions, the Halifax lender is expected to report during the week that there was a further marked decline in house prices. Specifically, we forecast the Halifax data to show that house prices fell 1.7% month-on-month in September, which would be the eighth successive decline. This would cause prices to be down 12.5% year-on-year in the three months to September. This is the measure that the Halifax prefers to use, as it believes this avoids the volatility that can occur in house prices from month to month. House prices are seen down 13.8% year-on-year in September itself.

Global Insight forecasts house prices to fall  16% overall in 2008, and by a further 15% in 2009. As a result, house prices are seen falling 29% in nominal terms from their August 2007 peak of £199,612 on the Halifax measure, to stand at £140,774 at the end of 2009. Reduced falls in house prices are expected in the first half of 2010, taking them down to a low of £133,736, which would be 33% below their August 2007 peak. House prices are then seen flattening out in the latter months of 2010.

By Howard Archer

7 Oct -Industrial Production, August (Month-on-Month): -0.1%
7 Oct - Industrial Production, August (Year-on-Year): -1.9%
7 Oct - Manufacturing Output, August (Month-on-Month): -0.2%
7 Oct - Manufacturing Output, August (Year-on-Year): -1.6%
8 Oct - Nationwide Consumer Confidence Index, September: 49
9 Oct - Visible Trade Balance, August (GBP/Mn): -7.6
9 Oct - Non-EU Visible Trade Balance, August (GBP/Mn): -4.5
9 Oct - Total Trade Balance, August (GBP/Mn): -4.5
During Week - Halifax House Prices, September (Month-on-Month): -1.7%
During Week - Halifax House Prices, September (Year-on-Year): -12.5%