UK faces rough ride as growth dips towards 1%

The global economic slowdown is set to hit our nearest and largest neighbour - Britain. It remains to be seen how significant the slowdown will become, but even British officialdom is now admitting that difficult times lie ahead.

Many forecasters are predicting British growth in 1999 of just 1 per cent or even below, the manufacturing sector is now in recession and even the important bell-wether of London house prices has fallen by about 10 per cent over the past six months.

Despite all this, British interest rates remain at 7.5 per cent, the level to which they were increased in June. Admittedly the markets are expecting a cut by October, but if one compares the deteriorating position in Britain with the Republic's own continuing boom, the fact that Irish interest rates are about 1.3 percentage points below British levels - and will fall to almost 4 per cent below those of Britain by year end - seems inappropriate.

Of course there have been several times over the past year when the markets have assumed that the next move in British rates would be down, only to be disappointed by yet another rise. But this time it does appear that things are different.

Key indicators now point to lower interest rates in Britain. For much of the period since last autumn, earnings in the private sector have been rising far quicker than the Bank of England would like and this was the main reason for the most recent rate rise.

But earnings growth has slowed sharply over the past few months and in the year to July the rise was only 4.3 per cent. This is now back within the kind of range with which the bank will be comfortable; it worries that earnings growth above 4.5 per cent is dangerous for the economy - that is the sum of the inflation target and the longrun rate of growth of productivity in the economy, which is assumed to be about 2 per cent.

At the same time, the overall rate of inflation fell to 2.5 per cent in August. The governor, Mr Eddie George, told this month's Trades Union Congress conference, that signs of the inflation rate falling below 2.5 per cent would be treated just as seriously as signs it was going through that limit - implying that the bank will not be slow to reduce interest rates.

He also pointed out that the global economic turmoil had reduced the likelihood that the bank would need to increase rates any further. It could even increase the chances of inflation coming in below target, which would imply a cut. But the problem is that this is not necessarily the view of the independent rate-setting committee at the bank. And one day after Mr George's speech it emerged that a member of the Monetary Policy Committee had even voted for a rate increase at the last monthly meeting.

There is scope for disagreement on the appropriate policy stance in Britain. This is perhaps because a recent low rate of 6.2 per cent unemployed is a sign that labour markets are still tight. But many believe - and recent high-profile industrial closures suggest - that unemployment is unlikely to fall any further and, indeed, if job losses do start we could be seeing even more British workers arriving over here looking for work, particularly in the services and construction sectors. There are those who argue that the bank may be taking too hawkish a line in its determination not to cut rates too soon and warn that there is a danger the economy could be plunged into overall recession if rates are not cut soon. Almost every set of official data in Britain now points to a slowdown. Manufacturing output and exports are both deteriorating, having taken the brunt of the impact of sterling's recent strength.

Confederation of British Industry industrial orders are at their lowest for some years while retail sales have reached a low not seen since 1992. Construction activity is down, in line with the slowdown in house prices, and there are now fears that large-scale job losses may be on the way.

Lower interest rates should lead to further declines in sterling, which has already fallen more than 8.5 per cent from its peak earlier this year. That is reasonably good news for Irish inflation. According to the Central Bank here, about half our inflation is "imported" through the exchange rate and therefore a significant proportion of the recent deterioration can be put down to the falling value of the pound against sterling last year. Some retracement of this should therefore be good for our economy.

Just as the Irish currency fell against sterling as British interest rates rose, so it should rise as rates come back. One of the most important aspects of this from the Irish economy's point of view will be the extent and speed of the cuts and the impact these have on sterling's level against the deutschmark.

In the past, some of the impact was cushioned as we tagged along on sterling's coat-tails, moving up and down against the mark. But since the announcement of the revaluation of the pound's central ERM rate in May, we have been pegged against the mark at around DM2.50. At the end of the year we will be permanently fixed at DM2.4830 and thus the full impact of sterling's moves will be felt on our exchange rate against it.

Sterling already has some interest-rate cuts built into its price and indeed many expect the first cut to come as early as next month. But even if it does not materialise until the end of the year - as the bank waits for confirmation that inflation is indeed coming back - the general path for sterling is expected to be downwards.

The average forecast is now for about 1 percentage point off interest rates over the next six to nine months. According to forecasters, this should lead to sterling trading around DM2.77 at the end of the year and to as low as DM2.66 by the middle of next year.

The optimum for the Irish economy is probably a sterling rate of around DM2.77, which leaves the pound at 90p against sterling. This is still low enough to offer exporters a competitive advantage into our largest market, but to also limit the downside for importers. A sterling rate higher than about DM2.50 could spell trouble, as it is difficult for the economy to operate at above parity to sterling and over the longer run our competitiveness could suffer.

But of course it will also be important for our economy that Britain does not plunge into outright recession which would lower demand. A few relatively quick rate cuts over the Irish Sea would probably suit the authorities here best and may even eliminate a little of the need for a very restrictive tax policy in our Budget in December.