King's Hands `Tied' as U.K. Economy Edges Closer to a Recession

By Brian Swint and Jennifer Ryan

July 10 (Bloomberg) -- Bank of England Governor Mervyn King may have little option other than to stand by and watch as the U.K. edges closer to its first recession in a generation.

Inflation accelerated to the fastest pace in more than a decade in May, making it harder for King to cut interest rates and help an economy threatened by falling house prices, record oil costs and tighter credit. Policy makers will probably leave the key rate at 5 percent today, according to all but one of the 49 economists in a Bloomberg News survey.

``Their hands are tied,'' said Amit Kara, an economist at UBS AG in London. ``The outlook for growth has clearly deteriorated, but on the flip side inflation is set to get worse. It's hard to see them doing anything other than holding rates unchanged.''

Prime Minister Gordon Brown's popularity is waning as the deteriorating economy erodes consumer confidence and companies including homebuilder Persimmon Plc and Barclays Plc cut jobs. King, chairing the first rate decision of his second term today, has already signaled that Britons should brace themselves for a decline in living standards.

Inflation accelerated to 3.3 percent in May, exceeding the government's upper 3 percent limit for only the second time in a decade. At the same time, surveys show services and manufacturing industries contracted in June, billionaire investor George Soros says a recession is ``likely'' and Lehman Brothers Holdings Inc. says the economy may start to contract this quarter.

``I know that some families will find it particularly difficult,'' said King, who doesn't expect a recession, on June 19. ``These changes to our spending power and to the housing market are real shifts that, although not easy to accept, we cannot side-step.''

Voter Confidence

Brown is losing Britons' confidence as growth slows. Seventy- two percent of respondents said they're not satisfied with his performance since he succeeded Tony Blair last year, according to a poll by Populus Ltd. published July 7. A separate poll last week showed voters are more concerned about inflation now than at any time since 1990.

Consumer confidence fell to the lowest in 18 years last month, GfK NOP Ltd. says. Marks & Spencer Group Plc lost a quarter of its value on July 2 after saying trading conditions won't improve for two years. Persimmon, the U.K.'s second-biggest homebuilder, said July 8 it's eliminating 1,100 jobs.

``A recession could really put the bank into a tough position,'' said Peter Newland, an economist at Lehman.

Raising Rates

For now, King and his colleagues on the nine-member Monetary Policy Committee are signaling they're more likely to follow the European Central Bank and raise rates rather than cut them. At least four policy makers have said they considered increasing borrowing costs last month and King said June 26 that inflation may exceed 4 percent this year.

The ECB last week raised its benchmark lending rate to a seven-year high of 4.25 percent. The Federal Reserve's benchmark stands at 2 percent.

``The bank isn't in a position where it feels it can cut rates,'' said David Page, an economist at Investec Securities in London. ``They're going to have to leave rates on hold until next year.''

U.K. borrowing costs are rising independently of monetary policy as the credit squeeze deepens. Brown was forced to nationalize Northern Rock in February and Bradford & Bingley Plc, the biggest lender to U.K. landlords, was last week unable to complete a rights offer to boost capital.

`Grave Concern'

Banks are also refusing to pass on the Bank of England's three rate cuts since December, threatening to exacerbate the housing slowdown. The rate on a home loan fixed for two years rose to 6.63 percent in June, the highest since February 2000, the Bank of England said yesterday.

Labour Party Deputy Leader Harriet Harman, standing in for Brown in Parliament yesterday, said ``the current state of the U.K. housing market is of grave cause for concern.''

``We are at a dangerous point when businesses are starting to act like a recession is due,'' said Adam Lent, head of economics at the Trades Union Congress, which represents 7 million workers and is calling for a rate cut today. ``The MPC needs to send a clear message that it is doing all it can to ease the credit crunch.''

While King says a sharp slowdown could push inflation below its central 2 percent target, giving them room to ease policy, economists including Lehman's Newland say a contraction would create as many problems as it would solve.

``Once people feel like the economy is in a downward spiral it becomes harder to get the economy back on an even keel,'' said Newlannd. ``No one wants one.''

To contact the reporters on this story: Brian Swint in London at bswint@bloomberg.net; Jennifer Ryan in London at Jryan13@bloomberg.net