The British economy is about to enter a phase of technical recession. And the prospect of a further rise in inflation towards five per cent later this year clearly reduces the chances that the Monetary Policy Committee (MPC) will be able to respond to the economic downturn by cutting interest rates in the near future.

The MPC can cut interest rates whilst at the same time writing letters to explain why inflation is more than one per cent above its target, but it is likely at least to want evidence that inflation has peaked. Accordingly, some economists now expect only one cut in rates during the rest of this year, probably in December, and even that might not come after all.

This is considered to be bad news for the housing market, where a very sharp adjustment is clearly underway. Housing sector experts have recently revised their house price forecasts to incorporate a fall of 35 per cent in the next two years.

The MPC has so far taken a sanguine view of the link between housing and the rest of the economy. But every previous major housing downturn has been accompanied by a sharp slowdown in the growth of household spending. So now spending is expected to stagnate next year, but some see a clear risk of outright falls.

According to Capital Economics Limited, a London based research firm neither is there much chance that other sectors will compensate. Investment looks set to fall as the housing downturn hits residential investment and business investment also softens. Meanwhile, although the lower exchange rate will eventually provide a boost to net exports, this is unlikely to come until global demand starts to pick up significantly, which may take some time.

The upshot is that, after growth of around 1.7 per cent this year, the UK economy is expected to expand by just 0.5 per cent or so in 2009. What’s more, while the quarterly path of growth is clearly uncertain, there is a strong chance at some point of a technical recession in the form of two consecutive quarters of falling output.

Whether or not the economy actually enters recession, the consequences of the downturn will be severe. Aside from the drop in house prices, unemployment could rise by almost one million by the end of 2010. Meanwhile, government borrowing is set to rise to around £60 billion per annum, comprehensively breaking the Chancellor’s fiscal rules, while the sterling exchange rate could fall significantly further.

The one silver lining is that current concerns over the inflation outlook should gradually fade, allowing the MPC to cut interest rates all the way to 3.5 per cent or so next year, way below the path currently expected by the markets. Along with lower house prices and a lower pound, this could eventually pave the way for a period of better-balanced growth in the UK economy. But there is a very painful period of adjustment to get through first.

The news on the housing market over the last month has simply been dire. The Nationwide, a leading building society recorded its eighth consecutive fall in house prices in June, leaving prices some eight per cent below their autumn peak.

And the collapse in the number of mortgage approvals to well below the levels reached in the early 1990s suggests that, by the end of the year, prices will have fallen by 15-20 per cent. But the further deterioration in the inflation news means that, while the MPC is unlikely to raise interest rates, it is unlikely to cut them again until late this year at the earliest.

Output and Industrial indicators show that activity has slowed fairly sharply even though the full impact from the housing market downturn and the credit crunch has yet to be felt.

Household indicators show that mortgage approvals have plummeted. There are still some signs of consumer resilience, though, especially in May’s strong retail sales figures. External indicators have continued to show little evidence that exporters have started to feel the benefits of the sharp fall in the pound.

Labour market indicators have revealed further rises in unemployment. Pay growth remains subdued. Inflation indicators showed CPI inflation rising to 3.3 per cent in May, triggering a letter from the Governor of the Bank of England to the Chancellor. Money/Financial indicators have continued to focus on the bad news on inflation rather than the bad news on activity. Equity prices have started to fall again.

The sharp slowdown in the UK economy seen in recent quarters has come before the full impact of the credit crunch and housing market slowdown has been felt. The downward revision to GDP growth in Q1, from 0.4 per cent q/q to 0.3 per cent, left the economy growing at its slowest rate since 2005.

The slowdown appears to be taking its toll on companies. The growth in the profits of non-financial, non-oil companies has slowed sharply. The likelihood that it will slow further probably partly explains why companies expect to pare back their investment spending.

Indeed, the recent activity surveys suggest that GDP growth is likely to slow further in Q2. And the boost from the lower pound looks unlikely to prevent the level of manufacturing output from falling outright. The GDP growth is expected to slow to just 0.5 per cent next year.

The Nationwide reported that house prices dropped 0.9 per cent in June and were down 6.3 per cent from a year ago. This is the fastest drop since 1992. Even officials think the market will fall 5-10 per cent at the least. One expert estimated last week that by the end of next year 1.2 million people could be in negative equity.