A steady weakening in the housing market will prompt a sharp slowdown in consumer spending next year, dragging growth to a three-year low, the Treasury forecast yesterday.

The Pre-Budget Report blamed turmoil in the financial markets and higher-than-expected interest rates as it slashed its projections for consumer demand.

Details in the report revealed that the Treasury expects demand to slow to between 2 per cent and 2.5 per cent next year, sharply down from the peppy 3 per cent pace it forecast for 2007.

The prediction means that GDP growth next year will be half a percentage point lower than Gordon Brown forecast in March.

Gloom surrounding the future of the housing market was reflected by the report, which pointed to evidence that house price increases have fallen back since May: “House price inflation is expected to continue to ease over the coming year.”

The Treasury also pointed to the five interest-rate rises since August 2006, which it said “can be expected to impact on growth in 2008”.

It continued: “In addition, disruption in financial markets has meant economic prospects have become more uncertain, and events need to unfold further before the impact on the economy can be rigorously quantified.”

With a “more uncertain” global economic outlook as a result of the US sub-prime mortgage crisis, the Treasury gives warning that the American economy could slow further and pose risks to demand for British exports.

Growing inflationary pressures, particularly from energy and food, are another concern for both developed and emerging economies, the Treasury said.

It added that Britain could be hurt more than most countries by the credit squeeze because it has a larger financial sector than most other economies.

But while the report said that it has assumed that the credit squeeze will hit household and company spending “in the short term”, it implicitly relied on the effect not lasting long.

The Treasury has pinned its fiscal projections on growth rebounding to its trend rate of between 2.5 and 3 per cent in 2009 and 2010.

The improvement will come about thanks to a slight increase in consumer activity and a turnaround in the terms of trade, the Treasury believes.

Noting that interest rates are now expected to fall in the coming months, the report added: “The UK economy has proved resilient to a number of shocks over the past decade, demonstrating the pay-off to the Government’s macroeconomic framework and promotion of open and flexible labour.”

Momentum in the financial and business services sector, which accounts for more than half of Britain’s output, is “likely to diminish in the short term”, the report concluded.

However, “the UK’s innovative financial sector was relatively quick to recover following periods of financial market disruption in 1998 and 2001”.

Between 2000 and 2004, GDP grew by 2.75 per cent per year, of which 2.25 per cent was thanks to the consumer and 0.75 per cent was driven by government spending, the figures showed. Business investment contributed 0.25 per cent and net trade was a drag on growth of 0.5 per cent.

That picture is set to change sharply by 2009, the Treasury hopes. It forecast that a slowdown in imports would cause net trade to have a neutral contribution to growth, helping to ease the problems caused by lower spending by both consumers and the state.

The consumer slowdown is part of a long-term rebalancing of the sources of growth between households and business investment, the report said.

Roger Bootle, economic adviser to Deloitte, the accountants, said: “The Chancellor’s acknowledgement of the darker economic outlook is marginal. He reduced the forecast for growth next year to 2 to 2½ per cent. We are forecasting 2 per cent, but the out-turn could easily be much worse than our forecast.”

Simon Ward, economist at New Star Asset Management, said: “Risks are high . . . the Budget forecast depends on an optimistic-looking growth rebound in 2009 as well as adherence to restrictive public spending plans and a further rise in the revenue share of GDP.”

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