Banks urged to pass on rate cuts as inflation nears peak

The Ernst & Young Item Club, which uses the same economic modelling as the Treasury, said the UK had already plunged into a recession and that unemployment is set to rise by 400,000 by the end of next year.

The leading economists said one "bright spot" amid the financial gloom is that inflation is likely to fall from a peak of 5.2 per cent, enabling the Bank of England's monetary policy committee to cut interest rates. But Peter Spencer, chief economist for the item club, raised the spectre of a recession as bad as that in the Seventies.

He said: "If those base rate cuts that we are looking to don't actually translate through into the rates that really matter mortgage rates and the like then of course we could be looking at a sort of Seventies-style recession.

"The assumption is that the Paulson Plan, the Darling Plan, will actually work but there is little sign of that yet." Many banks and building societies refused to pass on the full most recent cut of 0.5 per cent to 4.5 per cent this month.

The interbank lending rate is also remaining stubbornly high.

Mr Spencer added that if banks do lower mortgage rates as inflation falls, the economic downturn should be "relatively short and shallow".

Economic growth is due to fall by one per cent next year after already "deteriorating dramatically" in the last three months, according to the Ernst & Young forecasters.

The credit crunch would hit the UK "very hard" before a recovery in growth by one per cent in 2010.

Warning of house prices collapsing by 14 per cent this year, and 10 per cent in 2009, unemployment rising to 2.2 million by the end of 2009 and of a fall in investment, Mr Spencer stressed that the economic conditions were getting worse.

"The way the virus is spreading is like a pandemic," he said. "It's not just spreading from New York across the Atlantic. It is also spreading from the City to the real economy."

Companies are likely to see their profitability squeezed further, prompting firms to invest five per cent less in 2009, said the item club.

Real disposable incomes are tipped to remain flat in 2009, before rising in 2010, while consumption is seen falling by 1.2 per cent next year.

The housing sector would remain in "deep freeze" until confidence returns and the market bottoms out.