Britain is “uniquely at risk”, mainly because the Government has spent too much during the good times. The country faces house price falls of as much as 10%; while unemployment will rise to a ten-year high, with 200,000 people losing their jobs over the next 18 months.

Nice to see the world’s economic institutions are catching up to reality. But the OECD is still too optimistic…

The OECD has warned that the UK is in big trouble. It reckons the Bank of England needs to cut interest rates to 4.25%, but says it must hold off until next year because of inflation risks. The Bank will be announcing its decision on interest rates later today, and is widely expected to keep them on hold at 5%.

Why the government should be spending more right now but can’t

It also says that the Government probably shouldn’t be pulling in the reins in terms of public spending. The idea is that when times get hard, the Government spends a bit more to keep the economy ticking over until the private sector gets back on its feet.

But of course, this isn’t really possible, because the Government has bled the country dry during the good times. Gordon Brown has taken money that would once have gone into private sector pensions (which would have enabled more of our citizens to take care of themselves in the future, rather than relying on the state), borrowed a whole load more, and then sprayed it all over the public sector to almost no apparent effect at all (if you still have trouble believing this, read Squandered by David Craig – do remember to take your blood pressure pills first though).

As the OECD puts it, a little less bluntly: “The Government’s options have been limited by excessively loose fiscal policy in past years when economic growth was strong.”

It’s unusually tough talking from this type of body. Of course, the Treasury said the OECD was wrong. “The UK economy remains strong, and is well-placed to get through these global problems.” All I can say is, it’s little wonder that British consumer confidence is at a record-low ebb.

Those in power – both in the public and private sectors – of our key economic institutions seem to have one reaction to the credit bubble popping. That’s to stick their fingers in their ears and sing “la-la-la, I can’t hear you.” If it’s not Alistair Darling blethering about the UK being “well-placed”, then it’s any number of banking chief executives effectively saying: “Everything’s fine, our lending book is top notch, and even though the housing market is in meltdown, we will somehow be the one bank that can get through it unscathed. By the way, can any of you shareholders spare another few billion? No, don’t form a queue, people might get the wrong idea…”

A 10% fall in house prices? We should be so lucky

The unfortunate truth is that in fact, the OECD’s predictions that house prices could fall by as much as 10%, and that unemployment will rise by just 200,000, still seem quite tame.

Plenty of mainstream forecasters are now predicting falls of at least 10%. And during the 1990s recession, unemployment actually rose by closer to one million. And despite the increasingly desperate claims of the optimists, it is looking more and more as though this downturn could be much worse than the one in the 1990s.

One of the reasons behind yesterday’s 87-point drop in the FTSE 100 was a particularly worrying piece of economic data. The Chartered Institute for Purchasing and Supply released its services sector survey for May. The data showed that the sector shrunk for the first time in more than five years.

This is bad news. The service sector accounts for about three-quarters of Britain’s economic growth. But even worse was the news that employment saw its biggest contraction since records began in 1996, “with hotels and restaurant staff bearing the biggest brunt,” reports Edmund Conway in The Telegraph. And yet prices charged continue to rise. Companies are also more pessimistic than at any time since records began.

And all of this is already happening when we’re still at the start of the fall-out from the housing crisis – as the Halifax reported this morning (see below), prices are now down 3.8% year-on-year. The number of people in negative equity is creeping higher by the day.

It doesn’t matter what the Bank does today, or how many warnings the OECD gives out. The British economy is headed for recession. The only question is – how bad will it get?

Turning to the wider markets…

US stocks were mixed, with warnings that Moody’s may downgrade two major bond insurers (Ambac and MBIA) hanging over the market. The Dow Jones Industrial Average fell 12 points to 12,390. The wider S&P 500 was flat at 1,377, while the tech-heavy Nasdaq Composite gained 22 points to 2,503.

In Asia, the Nikkei 225 fell 0.7% to close at 14,328, as falling crude oil prices hit commodity trading groups. In Hong Kong, the Hang Seng climbed 0.2% to 24,161.

Brent spot was lower again this morning, trading at $121.02, with crude in New York trading at $122.25. Spot gold was at $875 an ounce. Silver was trading at $16.67 and Platinum was at $1,987.

Turning to forex, sterling was trading at 1.9515 against the dollar, and at 1.2636 against the euro. The dollar was last trading at 0.6478 against the euro and 105.87 against the Japanese yen.

And this morning, the Halifax reports that house prices fell by 3.8% in May compared to the same month last year. That’s the biggest annual drop since April 1993, when prices fell 2.4%.

Source: Why the Bank of England Can’t Save Britain from Recession

In the US — arguably an epicenter of the modern global monetary system — I see a central bank whose powers are constantly expanding. This progression dates back to its birth in 1913, but as recently as 1999 and 2003, parts of the Federal Reserve Act were rewritten and the Fed was given more power to create money.

Today, with progressive calls for action in the face of crisis, the Fed’s tentacles are potentially reaching directly into the credit and securities markets. This week alone, the headlines are rife with news of its “sweeping” new powers under Treasury Secretary Hank Paulson’s “plan.”

The Federal Reserve is in the midst of another historic interest rate-cutting campaign. Its official policy stance is that it recognizes the inflation risks, but worries more about growth, so it will inflate to sustain “growth.”

Money’s growing on trees

Its message has been, more or less, that money grows on trees, which is why Ben Bernanke’s moniker, “Helicopter” Ben, is catching on with the press. Gold bugs could not be more thrilled. Just recently, I wrote that we are seeing the best of all worlds for gold to shoot straight up a few hundred points.

But wait! “It’s not such a sure thing.” At least that’s what I thought I heard…from a voice in the wilderness. “What do you mean it’s not a sure thing? Look at ‘em flood the markets with liquidity. $100 billion here, a few hundred there.”

As I was about to sign off, the voice continued: “No, they are not inflating. They’re just creating confidence in the credit markets. Look at the ‘money’ numbers,” said the voice. “Forget credit. Look at the level of bank reserves and the adjusted monetary base. They haven’t grown since August. The Bernanke Fed is just pretending to inflate!”

Disinflation?

Perhaps I already knew what the voice was telling me. Like the title character in Tolstoy’s classic novel, The Death of Ivan Ilych, I was doing some soul searching and discovering hidden truths buried deep beneath the surface. The voice was my own, and it was telling me something I had yet to consider.

It has not escaped my attention that the narrow constituents of money supply are not expanding. I’ve written about it.

This disinflation was first apparent as far back as 2005, under Alan Greenspan’s tenure, when M1 growth hit zero percent on a year-over-year basis. He set it in motion through the rate hike campaign. The total value for US M1 has not changed in three years. But our “voice” insists that Bernanke is running a different, more deflationary policy than Greenspan — even though under Bernanke’s reign, since 2005-06, the broad credit aggregates have reaccelerated and the tightening campaign abandoned, and reversed. Clearly, the Bernanke Fed is running a different policy.
But it is difficult to call it a more deflationary one.

Bernanke’s Fed

Okay, so it has kept M1 flat, and slowed the growth in the monetary base a wee bit further (which has no doubt contributed to the crisis). And since August, the Fed has not expanded bank reserves overall, even though it has slashed its policy-setting interest rate by 300 basis points, has taken other measures to ensure short-term liquidity and talks as if it is ready to underwrite almost any insolvency.

We may point out that if the Fed wanted deflation, it would have already arrived. If, for example, Bernanke actually did nothing, the monetary base would have probably shrunk.

At a minimum, the Fed is inflating just enough to replenish erosion in bank reserves and the market’s confidence. The thrust of all of its actions has been to cheapen money and credit and inflate.

That is not to say there aren’t any deflationary forces in the system — just not ones produced by the actions of the Federal Reserve System so far. If there is deflation in the system, stable money proves the Fed is inflating. If it were pursuing a deflationary policy, you’d have seen a few more Bear Stearns by now — and it is unlikely that the broader credit aggregates like M3 and money with zero maturity (MZM) would be expanding so furiously.

Sure, there is a run on risk, and this risk aversion is causing some asset deflation, which in turn is producing a lot of short-term liquidity. So the Fed hasn’t had to create a lot of net new notes to push rates down, yet. Consequently, so far, it is merely underwriting a lot of the market’s current confidence, rather than monetizing it. But it does not necessarily follow from stable money supplies that the Fed is deliberating a deflationary policy.

According to Bloomberg, traders now see a one-in-five chance of a half-point reduction in the benchmark rate, to 1.75 percent, at the April 29-30 Fed meeting.

Bernanke told congress yesterday that the Fed is “ready to respond to whatever situation evolves,” and referred to “considerable stress” in markets.

New York Fed President Timothy Geithner said yesterday that policy makers must “continue to act forcefully.”

“Today, with progressive calls for action in the face of the credit crisis, the Fed’s tentacles are potentially reaching directly into the credit and securities markets,” says Ed Bugos in The Daily Reckoning.

“This week alone, the headlines are rife with news of its “sweeping” new powers under Treasury Secretary Hank Paulson’s ‘plan.’”

“The Federal Reserve is in the midst of another historic interest rate-cutting campaign. Its official policy stance is that it recognizes the inflation risks, but worries more about growth, so it will inflate to sustain ‘growth.’”

“Expect a continued erosion of the US dollar as interest rates are lowered further to avert depression and as inflation subsequently morphs into hyperinflation,” says John Browne in Today’s Financial News.