The UK economy has “deteriorated dramatically” in the past three months, and is already in a recession, top forecasters have suggested.

The Ernst & Young Item Club says the UK will shrink by 1% next year, before recovering in 2010 and growing by 1%.

The Item Club’s chief economist, Peter Spencer, told the BBC: “Recession is already baked in the cake.”

But one “bright spot” is that inflation is likely to fall, enabling the UK to cut interest rates further.

The group said that company profits had already been damaged by very high commodity prices.

While recent actions taken by the government to shore up the banking system are welcome, the credit crunch will hit the economy “very hard”, Ernst & Young warned.

Mr Spencer said: “Even if equity markets stabilise and we begin to see capital flowing around the international financial system again, we are still looking at a domestic and global economy that will be in recession for the next 12 months.”

Rising unemployment

However, Ernst & Young forecasts that with plunging interest rates, falling inflation, and a fundamentally strong economy, the recession will be “relatively short and shallow”.

“We desperately need a global solution given the heavy dependence of our banks and borrowers on cross-border banking flows” Peter Spencer, chief economist, Ernst & Young Item Club

The group is not alone in thinking the UK has entered a recession – which is typically defined as two quarters of negative growth.

A recent quarterly survey of 5,000 businesses by the British Chambers of Commerce (BCC) also said the UK was in a recession.

Companies are likely to see their profitability squeezed further, prompting firms to invest 5% less in 2009, the Item Club predicts.

As a result of the slowdown, widespread cuts in investment and employment are “inevitable”.

While the largest job cuts so far have been in finance and housing – the sectors most closely linked to the recent turmoil – the effect will spread further.

It said it expected unemployment claims would hit 5% by the end of 2009, double the rate at the end of 2007.

Credit ‘expensive’

The report comes after recent data from the Office for National Statistics underlined the weakening labour market.

The number of people out of work in the UK rose sharply in the three months to August by 164,000 compared with the previous quarter, marking the biggest rise for 17 years.

Until September, accelerating inflation had been a major concern – latest figures show the annual CPI rate reached a 16-year high of 5.2% last month.

But prices have fallen recently, most notably for energy, and analysts expect September’s figure to mark a peak.

However, real disposable incomes are set to remain flat in 2009, before rising in 2010, the Item Club said.

The research group forecasts that consumption will fall by 1.2% next year, with credit continuing to be hard to obtain and unemployment expected to rise.

The Item Club predicts house prices will fall 14% by the end of this year, and drop a further 10% next year.

Until the bottom of the market is reached and confidence returns the housing sector will be in “deep freeze”, it says.

“Last year consumers were able to handle the income squeeze by borrowing and dipping into their savings,” said Mr Spencer.

But this year “it is a very different story with credit harder to access and far more expensive”.

Fiscal policy

The Item Club said recent government intervention had pulled the UK back “from the brink” but the banking system was “in intensive care”.

Earlier in October the UK government set out a number of initiatives to rescue the banking system by making £400bn available.

But the report said that addressing problems in the UK’s finance system could not be dealt with in isolation.

“We desperately need a global solution given the heavy dependence of our banks and borrowers on cross-border banking flows”.

Longer term it said the recent financial crisis had left huge question-marks over bank regulation and governance, as well as fiscal policy.

News reported by The BBC

The economic slowdown is deepening and a slew of indicators published today point to falling confidence, contracting markets and gloomy predictions for recovery.

The UK economy will struggle to avoid recession in 2009 as inflation remains above target and unemployment rises, the Ernst & Young ITEM Club will predict today.

Consumers will feel the squeeze as the rising cost of credit repayment and essential spending on food and energy puts pressure on household budgets, forcing people to rein in spending after years of cheap borrowing, according to the ITEM summer forecast, which also predicts oil prices rising to $150 a barrel.

With credit markets still largely frozen, mortgage finance will remain restricted and house prices will fall further, ITEM said. Property prices will drop about 10 per cent this year and 6 per cent in 2009, with values outside London suffering worst. Volumes will fall about 35 per cent in 2008 with a knock-on effect on associated spending.

Peter Spencer, chief economist to the ITEM Club, said: “Both on the high street and in the housing market, it is going to get a great deal worse before it gets better.

“We have already seen a housing crisis that has morphed from a credit crunch to a general collapse in confidence as prices have tumbled. Our worry is that without the usual medication from the Bank of England, which would have nasty inflationary side effects in this environment, the consumer will follow suit, moving from their current state of denial into a state of despair.”

But as consumer spending drops, the Bank of England will cut interest rates, perhaps as early as November. “The weakening economy should allow the Bank to cut rates this winter without running the risk of inflationary second-round effects,” Mr Spencer said. “We expect interest rates to fall to 4 per cent by the end of 2009.”

It is not only consumers that are succumbing to the falling confidence that started with last year’s crisis in the banking sector. British business confidence has slumped to the lowest point since the recession of the early 1990s, according to the Lloyds TSB Business in Britain survey for July. The balance of firms expecting better, rather than worse, activity in the next six months fell sharply to minus 8 per cent, from 18 per cent in January. The slump in morale reflects companies’ experience in the first half of the year when a balance of just 6 per cent had rising sales.

The balance expecting higher order book levels slumped to zero from 22 per cent six months earlier. Just 2 per cent predict higher sales, down from 28 per cent, and profit expectations have dropped to minus 25 per cent from 4 per cent – the biggest half-year decline recorded.

Such apprehension is having a tangible effect. Not only is merger and acquisition (M&A) activity already falling at its fastest rate since the dotcom crash, slipping from a high of 607 takeovers in the second quarter of 2007 to just 398 in the same period of this year. But it will continue to fall for another nine quarters, according to analyst by accountancy group Grant Thornton.

David Brooks, the head of M&A at Grant Thornton, said: “If present conditions continue, it could take some years to climb back to the M&A peaks we saw midway through last year, as it did after what was a comparatively mild economic shock post dotcom. Unfortunately, it seems increasingly likely this is best-case scenario, and recovery could take even longer this time.”

Relief could come from foreign takeovers of UK companies, which have held fairly steady. Overseas companies took advantage of Britain’s relaxed approach to foreign ownership with £29bn of deals in the first half and Santander’s bid for Alliance & Leicester is one of a number of big deals in the pipeline.

Globalisation may also act as a cushion. “The developing world is cash-rich and looking to spend, and the UK is putting a for-sale sign in the window, so expect more big-ticket acquisitions by foreign companies to be announced in the coming months,” Mr Brooks said.

The pain in the property market also shows little sign of abating. Rightmove, the property website, will say today that average asking prices dropped by more than £4,000, or 1.8 per cent, in the past month alone.

The average property in England and Wales is now worth £235,219 – 2 per cent less than it was last year. Not only are new instructions to estate agents down by 20 per cent year on year, but properties that are on the market are not selling. Agents have an average of 77 unsold homes on their books, the sixth consecutive monthly rise.

News reported by The Independent