THE spectre of negative equity has raised its head after an economic think-tank said Britain's economy could fall into a deflationary spiral by the middle of 2005.

House prices would fall by almost ten per cent next year and by about 15 per cent in both 2005 and 2006 if UK economic growth fails to recover from its current weak rate, the Ernst and Young Item Club said.

That would imply an "explosion" in the number of households with negative equity - where homeowners owe more to their mortgage lenders than their properties are worth, the Item Club said.

Negative equity was last a problem during the early 1990s and there has been fresh talk that overheating in the housing market may trigger a return.

The Item Club called such a scenario extreme, and said the probability of it happening was very low due to the UK's flexible policy framework and scope for further falls in interest rates.

But it said: "It is not difficult to see signs of possible deflation in the UK."

The Item Club is the UK's only economic forecasting group to use the Treasury's model of the UK economy.

Growth in gross domestic product during the past two years has been well below its long-term trend rate, indicating a "growth recession", it said.

While ministers estimate the UK's long-term trend or sustainable growth rate to be about 2.75 per cent. GDP has risen at an average annualised rate of 1.8 per cent during the past two years.

Growth was particularly weak in the first half of this year, rising at an annualised rate of just 0.8 per cent - its weakest performance since 1992.

If growth was to remain at that rate, due to lack of corporate investment and growing consumer debt, the Treasury model suggests that the UK would enter a deflationary spiral by the middle of 2005, the Item Club said.

However, Item said it attached a "very low probability" to such a scenario.

There are signs that the worst of the recent growth recession is over, with surveys of both manufacturing and services strengthening since the spring.