Getting personal regarding the rules?

If a fretful Gordon Brown was watching on Wednesday as the Bank of England unveiled its latest strategy for the British economy, the Prime Minister may well have wondered whether he might end up feeling much the same way over his decision last month to hand Mervyn King a second term as Governor of the Bank.

Mr King’s flinty and uncompromising message on Britain’s economic prospects was bleak enough to leave any occupant of No 10 wringing his hands over the likely evaporation of the country’s “feelgood factor”.

With the MPC caught between slowing growth and rising prices, a succession of base rate cuts throughout 2008 looks unlikely. Yet without a significant monetary stimulus to the economy, Gordon Brown must be afraid that he will be seen as the Prime Minister who presided over the death of New Labour as the party of strong economic performance.

Mervyn King made the message clear: accept base rate needs to stay where it is, or be willing to see CPI rise above its target ceiling of 3.0%.

Mr King left little doubt that the Bank sees a torrid time ahead for the economy. Battered by the world downturn, a tightening of lending conditions for households and businesses and a severe toll on consumer demand from soaring food and energy bills, as well as a sliding housing market, Britain’s growth is set to slow sharply during the next 12 months. The Bank’s central view is that annual growth in GDP will reach a nadir of 1.7 per cent by the summer.

This downswing may be severe enough to take the economy to the brink of a technical recession, the Governor conceded. He admitted, too, that the squeeze on household spending power from the surging cost of food and fuel spelt a “genuine reduction in our standard of living”.

The time lags usually associated with interest rate policy (somewhere between 12 and 24 months) combined with concerns that higher prices will fuel higher wage demands, in turn leading to higher prices (the technical term for this is a wage-price spiral), makes anti-inflation policy in 2008 extremely difficult to predict.

Will slower growth (including the genuine prospect of a technical recession later in the year, where GDP growth falls below inflation for at least two consecutive quarters) help to contain inflation (via a dampening of prices because of low demand rather than higher costs of supply)? Or will supply-side issues continue to push prices higher (and prevent the base rate falling in the process)?

Perhaps a fiscal stimulus is the answer? This is the response of the US administration with the dollar equivalent of £76bn of tax breaks being announced in January of this year. But the Treasury is limited by its own Code of Fiscal Stability and these rules are already being strained by the costs associated with propping up Northern Rock.

Perhaps it’s time to rewrite the rules - either on fiscal stability or monetary policy. But any attempt by the government to take a more active, short-run role in propping up demand in the ailing economy will only add to the clamour from the opposition benches that we are seeing a return to the bad old days of disastrous economic management by a Labour government.

The next few weeks will see results announced from the banking sector and more inflation data. With more pieces in place, a better picture of the UK economy will emerge - as well as the hard choices our policy-makers will face this year.