By Steve Schifferes
Economics reporter, BBC News
The Chancellor is facing difficult economic times ahead
When the credit crunch began last August, many policy-makers believed that the disruption to financial markets was likely to be short-lived and have only a small effect on the economy.
Now it is becoming clear that the credit crunch is likely to last longer, spread more widely across the world, and hit economic growth more deeply than previously believed.
And it also clear that the UK will not escape some serious effects of the downturn.
The cut in base rates by the Bank of England on Thursday, the third in the last five months, is a recognition that, despite inflationary pressures, the risks to the UK economy are on the downside.
However, even the latest gloomy economic forecast from the International Monetary Fund, published on Wednesday, is not predicting that the UK will go into recession.
But its growth forecast of just 1.6% for both 2008 and 2009 will be the lowest since the early 1990s, and is nearly 1% below the trend growth rate of the economy, and government projections for 2009.
The UK housing market is vulnerable to a slowdown, the IMF says
That could eventually lead to significant job losses, with some economists arguing that a 1% below trend growth translates into 200,000 fewer jobs.
And it could mean a further squeeze on government spending, or a rise in taxes as government borrowing is already projected to rise to £45bn this year.
The government argues that its relatively low government debt, and low inflation, provide scope for further action, especially by the Bank of England in cutting interest rates.
But the problem is that such rate cuts are not likely to be passed on to consumers, especially mortgage holders, because the banks have become chary of taking on more risk.
The UK is more vulnerable to an economic slowdown because of the high levels of debt held by households, whose incomes will be squeezed by higher interest rates.
It is also vulnerable because of the high levels of house prices, which are above the historic relationship between house prices and average incomes.
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If the banks hadn't handed credit out like candy we wouldn't be in this mess
Natasha Reynolds, Southampton
In the past few years, equity withdrawals from the housing market have boosted consumer spending and helped keep the economy afloat.
Now the fall in house prices, especially if they gather pace, could discourage people from spending on big items if they feel less wealthy - and find it more difficult to get credit for such purchases.
The IMF points out there can be a downward spiral, with credit markets and housing markets reinforcing one another.
This is clearly what has been happening in the US, where the falls in house prices - already down by 10%, and expected to fall further - have led to sharp falls in the value of many assets held by banks.
The UK is also vulnerable because the financial sector is such a large part of its economy, accounting for up to a third of the increase in GDP in recent years.
But the growth of the UK financial sector has been driven by its connections with the international economy, with many foreign banks locating in London, encouraged by the light touch regulation of the government.
The sharp downturn in that sector could have a knock-on effect on house prices, especially in the London region, as well as government tax revenues.
The IMF has warned that the main downside risk in the current situation is that the losses to financial institutions, already estimated at nearly £500bn ($1 trillion), could increase further.
This could potentially put their balance sheets at risk and leading to a financial meltdown.
The UK has been hoping that as consumer spending slows, a weaker pound would boost manufacturing exports to other countries, thus rebalancing the economy.
But a sharp economic slowdown in the UK's major export markets in Europe and North America could make it much more difficult to rely on this mechanism for growth.
What can be done?
Given the international nature of the crisis, the UK government's options seem to be limited.
The government has already said it is prepared to let public borrowing increase in the short term to avoid pushing the economy further towards a slowdown.
But it has limited scope for further tax cuts or spending increases.
And it is hoping that current and future interest rate cuts will eventually feed through into a boost to growth.
The government is therefore focusing on how to unfreeze the financial markets which are making it more difficult for UK banks to borrow for mortgages.
But the freeze-up in the international credit markets is very much a global phenomenon, with banks and investors around the world suddenly having much less appetite for risk.
The Chancellor is hoping that concerted global action could lead to greater disclosure by banks and a return to confidence.
But although in the long term, better regulation might prevent banks taking on so much bad debt, it is hard to see a quick agreement among the major industrial nations that would add significant new resources.
As the crisis has originated in the US, it may be that a political resolution of the housing market problems cannot be reached until after the presidential election in November.