The Bank of England is set for a tight decision on interest rates this week, amid new evidence of sharply falling business confidence and a series of recent reports pointing to a sharp slowdown in the economy.

Though the City thinks Bank rate will stay on hold this week after recent comments from some members of the Bank’s monetary policy committee (MPC), the “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs, has voted by a narrow 5-4 to leave rates on hold.

Two of its members say the Bank needs to cut by half a percentage point to 4.5% to head off a sharp economic slowdown.

The two, Patrick Minford and Roger Bootle, warned of the need to cut aggressively. Bootle said the situation was “extremely dangerous”, and Minford described downside risks as “severe”.

That is also likely to be the verdict of one MPC member, David Blanchflower, who warned in a speech last week that the Bank had to cut rates aggressively if Britain is not to follow America into a housing slump and near-recession.

Two other shadow MPC members voted for a quarter-point cut this week. Another, Gordon Pepper, initially thought there should be a reduction, but changed his mind on the Bank’s unveiling of its £50 billion special liquidity scheme.

The MPC meeting comes as business is warning that the credit crunch has hit confidence hard, the Institute of Directors will report this week. The proportion of company directors who are more versus less optimistic about their firm’s prospects, compared with three months ago, fell to -17% in the latest survey, from -2% previously. A year ago optimism was very high, at +33%.

The balance of those directors who are more rather than less optimistic about the outlook for investment fell to -30% from -24% previously. A year ago this balance stood at +17%.

“The survey doesn’t say head for the lifeboats, but it does say remember where they are,” said Graeme Leach, chief economist at the Institute of Directors.

“The sharp fall in overall business optimism is very worrying and points towards a hard landing. Thankfully, other results in the survey suggest we can still achieve a soft landing over the 2008-9 period.”

Less pessimistic findings showed that a balance of 74% of directors think their businesses are performing well, while 45% claimed to be unaffected by the credit crunch.

Recent data show March and April were bleak months for the housing market and this has hit construction activity. April also seems to have been a washout for retailers, and manufacturing has slowed significantly.

A key data release before this Thursday’s interest-rate decision will be the purchasing managers’ index for the service sector.

Whether MPC members are minded to cut rates will depend partly on the Bank’s new economic forecast. Mervyn King, the governor, warned last week that he would probably have to write a letter to the chancellor explaining why inflation had moved above 3% and that it would probably remain above target for a considerable time.

In contrast, Blanchflower said there was a rising probability that a letter would have to be written explaining why inflation had dropped below 1% before his MPC term expires in May next year. Much will depend on the extent to which the Bank revises down its growth forecast.

Its predictions for 2009, which in February were for a speedy bounce-back in growth, are likely to be revised lower when it publishes its new inflation report this month.

According to a survey of analysts by Ideaglobal.com, there is a 30% probability of a cut in rates this week. But analysts see Bank rate dropping to 4.5% by the end of September, implying two reductions. RECENT DAYS have witnessed some extraordinary developments, most of them from the Bank of England. Time was when months would go by without a peep from the Old Lady. Now it has become a news-generating machine that Max Clifford would be proud of.

Development one was Mervyn King’s attack on the City’s reward culture, which many will applaud, though some would say a bit of performance-related incentive is a good thing. The governor’s salary of just under £282,000 – small in relation to many City salaries though with a pension pot of nearly £4m – rises 2% a year, come what may. That gives him an incentive to keep inflation on target but doesn’t reward or punish him beyond that.

Development two was a speech by David “Danny” Blanchflower, one of King’s colleagues on the Bank’s monetary policy committee (MPC). This was, it is safe to say, the most doom-laden speech ever from a UK policymaker, warning that Britain was likely to follow America into recession (whether the US is in recession is still open for debate after first-quarter numbers showed growth), that a fall in house prices of a third in two to three years “does not seem implausible” and the risk of something “horrible” arising from the credit crunch was significant.

Compared with the coded language normally adopted by anybody with anything to do with the Bank, this was a revelation. Blanchflower spends half his time in America and that may explain his gloom, but even there central bankers are a bit more guarded in their language. I am surprised this one got past the censors.

“Developments in the UK are starting to look eerily similar to those in the US six months or so ago,” he said. “There has been no decoupling of the two economies: contagion is in the air. The US sneezed and the UK is rapidly catching its cold.” I’ll return to that.

Development three, hard on the heels of this blood-curdling warning, was the apparent declaration from the Bank that the credit crisis was over and that banks should come out of their shells and start lending again.

This was not quite what its financial stability report was saying: that some gloom in financial markets may have been overdone, in that the scale of losses assumed in US sub-prime assets, a 40% default, looks too pessimistic. Financial markets are assuming many such assets are worth nothing, while on conservative assumptions, and allowing for further falls in American house prices, they are worth something.

The broader message was that the authorities could win one battle, to stabilise financial markets, only to lose a bigger one, that of stabilising the economy, The Bank thinks lenders, worried about bigger losses in asset-backed securities than are likely, could be entering overkill territory in scaling back activities, leading to “a self-fulfilling adverse cycle”. We saw some of this in March, when lenders were falling over themselves to turn away business, and mortgage approvals slumped to 64,000, a record low. As I have noted before, if thebanks tighten too much, they risk turning even Blanchflower’s extreme gloom into reality.

How serious should we take his warning that where America leads, Britain follows? I was surprised he used the house price /earnings ratio as the basis for predicting that properties could lose a third of their value. Steve Nickell, his former MPC colleague, did an effective demolition job on it three years ago, and few serious analysts believe the crude ratio is a useful valuation measure.

Constraints on housing supply (with housebuilding rates now in decline), more earners per household, lower mortgage rates, lower long-term real interest rates and other factors explain why the ratio of house prices to average earnings has risen. It probably has risen too much, but there is no good reason to believe it will return to its historic norm, established in very different economic and social circumstances.

As an aside, and I am not including Blanchflower in this, I get fed up with commentators who write that if the International Monetary Fund says house prices are overvalued by 30%, prices have to fall 30%. Basic maths tells you the required fall, if you accept the IMF’s numbers, is 23%. Try it on a calculator. Given that the IMFsaid it could not explain 30% of the rise between 1997 and 2007, the “required” fall is smaller – under 20%.

We can debate until the cows come home how what I think is a more modest overvaluation is worked off. House prices are down on a year ago and incomes are rising, so that process is under way. But what effect does the end of the house-price boom have on the wider economy? Blanchflower was clear. “I think it’s plausible that falling house prices will lead to a sharp drop in consumer spending growth,” he said.

Contrast that with a speech by Charlie Bean, the Bank’s chief economist, just last month. “Some commentators look at the historically strong correlation between house-price inflation and consumption growth and conclude that if house prices fell significantly, then that would also generate a sharp slowing in consumer spending,” he said. “But it is not clear that this need be so.”

In the end, the direction of causation may be less important than the result. In the early 1990s the housing market and consumer spending fell, the latter driving the economy into recession, because both responded to a sharp tightening of monetary policy – a doubling of interest rates – in thelate 1980s. It became self-feeding when unemployment rose and people realised the annual rises in cash income they had been used to in the more inflationary 1980s would not continue in the 1990s.

This time it is not the price of credit that is the problem but its availability, which is affecting housing and, if left unchecked, will hit consumers and businesses. In another stunning bit of news a few weeks ago, the Bank announced its £50 billion liquidity scheme for the banks. The quid pro quo for that should be that the banks move out of their overkill phase in reining back lending and return to something more normal. If not, the effort will have been wasted.

PS: Just as there is disagreement on the MPC, so there is on its shadow, which meets under the auspices of the Institute of Economic Affairs. It votes 5-4 to hold Bank rate this week. There are a couple of “Blanchflowers”; both Roger Bootle and Patrick Minford favour a half-point reduction to 4.5% this month. There were also two trimmers, with Kent Matthews and Philip Booth arguing for a quarter-point cut.

The five who voted to hold had different motivations. Gordon Pepper said the Bank’s £50 billion liquidity scheme had lessened the need forimmediate action on rates. Andrew Lilico said the Bank would lose credibility by cutting when monetary policy was ineffective, so it should keep its powder dry.

Anne Sibert and my near namesake David B Smith were concerned about uncomfortably high inflation. Trevor Williams of Lloyds TSB said the Bank should concentrate on restoring liquidity, not cutting interest rates.

So there is a debate to be had. The Shadow MPC’s minutes are on economicsuk.com, the Bank’s on bankofengland.co.uk. What should happen? I would cut by a quarter this week, if only to lower the bar for money-market interest rates. While not agreeing with everything Blanchflower said, risks to growth are greater than to inflation. The Bank’s last inflation report predicted a big bounce in growth in 2009, which is now looking less likely.

Commodity markets are fickle and should not dictate UK interest-rate policy. Gold has fallen 17% in the past few weeks. Will rates be cut? That’s harder. King’s comments last week suggested not, and two Bank “hawks” – Tim Besley and Andrew Sentance – voted against April’s reduction. The markets think there will be no change. But it will be close.

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