John Gieve: The credit crunch and the UK economy
Speech by Sir John Gieve, Deputy Governor of the Bank of England, to the Family Office
Leadership Summit, London, 22 September 2008.
* * *
Introduction
In recent days we have seen extraordinary developments in US financial markets. At the
start of last week we saw the collapse of Lehman Brothers and the merger of Merrill Lynch
and Bank of America; by Friday the US Treasury had rescued AIG, issued a guarantee of
Money Market Funds and an outline plan for a Resolution Trust that is now in Congress. And
this morning the Federal Reserve announced that Goldman Sachs and Morgan Stanley
would become regulated bank holding companies.
But I want today to concentrate on the broader economic impact of the crisis in credit
markets, which began over a year ago with the downturn in the US sub-prime housing
market. While the epicentre has remained in the US, it has already had a major impact on
the structure of our banking sector. Northern Rock was among the first casualties. And this
year we are seeing a significant consolidation within the UK banking sector, with Santander
purchasing Alliance & Leicester, Nationwide absorbing two smaller building societies, and
most recently the merger of HBOS and Lloyds TSB.
The turmoil has also affected all of the Bank's work; from the setting of interest rates, to the
scale and structure of our market operations, and to our joint work with the FSA and
Treasury to deal with institutions under stress and to help design an effective international
response to the crisis.
For example, like other central banks, we have adapted our money market operations to
provide the liquidity the banking system as a whole has required. First, we have allowed
banks to increase their reserve balances at the Bank, increasing the size of our overall
provision of central bank money; second, within that larger total, we have shifted the balance
towards longer-term lending as the terms of market finance have shortened; third, we have
widened the collateral we accept for longer-term repos. And in April, we introduced a special
scheme to provide banks with up to three years' finance for legacy assets which have
become illiquid.
Last week we offered extra sterling liquidity through our usual Open Market Operations and
provided US dollar liquidity as part of co-ordinated action with the Federal Reserve, ECB,
Bank of Japan and Swiss National Bank. We also extended the window in which banks can
swap their legacy assets under the Special Liquidity Scheme until January next year. Even
once the window closes, the Scheme's asset swap will provide liquidity for a period of up to
three years, something many people have not fully appreciated.
Events are still moving quickly, so I hope you will understand why I am not going to attempt a
live commentary on events. I hope that the massive and far-reaching measures the US
Government has now announced will restore greater calm and confidence in their banking
system. Stabilisation of US markets and banks should have a beneficial knock-on effect on
wider international markets too. But we will continue to monitor the situation closely, in
consultation with our counterparts in the US and elsewhere, in order to judge whether any
further measures are needed.
Inflation outlook
This morning I want to take a wider perspective and discuss how the credit crunch is
affecting the wider UK economy and draw some medium-term lessons for economic policy.
And the first point to make is that the turmoil in financial markets has not been the only shock
to our economy in the last 12 months. In any other week more attention would have been
given to the fact that for the second successive quarter the Governor had to write an open
letter to the Chancellor on behalf of the Monetary Policy Committee to explain why inflation
was more than a percentage point away from the target of 2%. In fact inflation has risen from
2.1% in December to 4.7% in August and it seems set to peak above 5% soon.
The immediate driver of that increase has been the international commodity cycle (Chart 1).
The rapid growth across most large emerging market economies (EMEs) in particular has
fuelled global demand for raw materials, which in the short term are in relatively fixed supply,
pulling their prices upwards. In August, oil prices were up 60% higher than a year earlier,
wholesale gas prices were up 90%, and food prices 40%.
These sharp increases in costs have fed into food and petrol prices and passed along the
supply chain, driving up the prices of other goods including in particular household gas and
electricity bills (Chart 2). But so long as the prices of wholesale energy and foodstuffs on
global markets stabilise at their new higher levels, their direct impact on inflation should wash
out after a year. In other words, by late 2009 these items would not be making any
contribution to the rate of consumer price inflation: whereas, at present, they are contributing
almost 3 percentage points.
Moreover there are some signs that the commodity cycle may have turned down. Since the
peak in July, the price of food has fallen by 10% and the price of crude oil has fallen by over
a quarter, and that is consistent with other indicators that point to a slowing in growth in both
emerging and advanced economies.
That good news on commodity prices has been offset somewhat in the UK by a falling
exchange rate. Sterling has been trading at around 1.8 against the US dollar - a year ago it
was 2.0. But the same arithmetic applies: such price level shocks need have no long-term
impact on the inflation rate.
In the medium term the real upside risks to inflation lie at home - in whether we see "second
round" rises in wages and prices in the domestic economy. It is to counter those pressures
that the MPC have judged it necessary over the last year for growth to slow and create a
margin of spare capacity in our economy. That makes it more difficult for companies to raise
prices and puts more pressure on them to restrain their costs.
It also re-emphasises our determination to get inflation back to the 2% target and thus
influences the expectations of financial markets, price setters, wage negotiators and
households generally. And expectations themselves have an important impact on inflation.
Broadly, the higher households' expect inflation to be, the less they are likely to save today.
Inflation expectations also shape workers' wage demands as they try to protect their
standard of living. And companies' expectations will shape the prices they set as well as their
willingness to concede cost increases.
We know from the inflations of the 70s, 80s, and early 90s that raising interest rates will in
time bring inflation down, even when expectations of future inflation are high. But we also
know how painful that process is. It works through the increased threat of bankruptcy and
unemployment. That forces a change in peoples' behaviour and their hearts and minds and
expectations follow. Conversely, the more confident people are that inflation will fall back the
less we have to rely on slowing the economy to force them to hold prices and wages down.
That is why the risk of inflation expectations drifting up has been such a central concern of
the MPC over the last year. In my view it has been particularly important through recent
months, when each forecast has been higher than the one before and each inflation figure
has exceeded the earlier forecast, not to confuse the central message that we will set policy
to bring inflation back down to target.
We have seen households' near-term expectations of inflation rise this year, but that was
inevitable given experience and our own forecasts (Chart 3). What matters more are
expectations of inflation over the medium-term, and whether they are consistent with the
target, and here the surveys are less alarming: according to the YouGov/Citigroup survey,
those expectations have fallen back a little and a gap has opened up between people's
perceptions of current inflation and their expectations of a year or more ahead.
We can use other economic data as a cross-check on what is happening to inflation
expectations. If households' expectations had become detached, we should expect to see
households spending more, and saving less, and pushing for larger nominal wage increases.
If companies' expectations had become detached, we should expect to see a broad-based
pickup in cost and price inflation. But consumer spending appears to be weak, nominal wage
growth remains relatively muted and once we strip out the impact of rising commodity prices,
output price inflation has been steady. To paraphrase Sherlock Holmes, if expectations have
become detached, it is curious that those dogs haven't barked. So in my view the news on
that front has been encouraging.
The impact of the credit crunch
And of course, we have been balancing that upside risk to inflation from the commodity price
shock against a downside risk that the credit crisis would drive down activity too far and push
inflation below target in the medium term. And the news on that front remains worrying.
The headlines are about the drama on Wall Street but the failure or rescue of even big and
well known financial firms matters mainly because of their knock on impact on the wider
economy. The last year has brought home once again why central banks have to be
concerned with financial stability as well as monetary stability and inflation. For the biggest
risk to the financial sector is also the biggest downside risk to the economy: namely that
damage to bank balance sheets would lead to tighter credit conditions, lower asset prices,
lower consumption and investment and to a severe feedback loop into more losses for banks
and so on down a spiral.
That feedback is already working to some degree not just in the US but in the UK too. Our
investment banks have suffered losses in their trading books and a wider group of banks
have lost money on their treasury books because of the fall in the values of structured credit
of all sorts. At the same time they have found that some of their major sources of finance,
notably securitisation and medium term unsecured lending, have dried up and others,
notably shorter term lending in money markets, have become much more expensive
(Chart 4).
What is more, all these effects have lasted longer than expected and seem set to continue
for some time. Banks have responded by hoarding liquidity and trying to reduce their
leverage by raising new capital (not without difficulty in some cases) and by constraining the
growth of lending. One direct effect has been a marked tightening of credit conditions over
the past year (Chart 5), which seems still to be underway. That in turn is pushing down asset
prices and demand.
Our forecasts and our policy decisions have reflected our best assessment of the likely
impact of this feedback. We brought down interest rates earlier in the year to cushion the
impact of the change in bank behaviour. In effect we have relied on the credit squeeze in
large measure to produce the slowdown we consider necessary. But we are fully aware of
the risk that the squeeze on banks and the feedback to the economy could prove more
powerful than expected.
That risk does not just arise from the drama of the last week or two. We will continue to work
for the return of calmer financial markets. But we should not rely on that to reverse quickly
the broader macroeconomic slowdown that is underway. Indeed there are still risks to the
downside and I thought it might be useful to spell out how they feed through the economy
and therefore make plain what indicators I will be focusing on in the next few months.
Any contraction in lending to the real economy can amplify the slowdown in demand (Chart
6). Increases in retail lending rates for those who can still get access to credit discourage
spending. Increases in credit rationing can have a more dramatic impact. If those households
and companies are unable to tap other sources of finance, then their spending will have to
fall back in line with income.
Spending on high cost durable goods - such as purchases of cars and white goods by
households and machines by companies - are likely to be particularly affected. And the
contraction in mortgage lending pushes down house prices, further eroding the value of the
collateral against which banks' loans are secured.
Tighter credit conditions raise income gearing, forcing households and companies to devote
a larger share of their income to servicing debt. And as the impact of those tighter credit
conditions bite on the economy, income is likely to be squeezed and that at the same time as
real incomes are being affected by higher food and energy prices. The slowdown in demand
will fall disproportionately on certain industries, starting with the house-building sector and
related services and lead to falls in employment. Some households and companies are likely
to be driven over the default threshold.
Tighter credit conditions could also affect the potential output of the economy - reducing the
capacity of the economy to produce goods and services. The economy's supply capacity
reflects not only the number of people who work and the number of machines at their
disposal, but also how productive our companies are at using that labour and capital to
produce output. And the innovations in new products and new processes which drive
productivity growth are financed in part by bank lending.
In short, the process of deleveraging that was designed to alleviate pressure on banks'
capital position can lead to an additional wave of credit losses, coupled with higher write-off
rates, given the lower level of property prices (Chart 7). And, welcome though the reforms of
Basel II and accounting rules are in many respects, they can accentuate the squeeze on
capital because the requirements are based on risk weights which rise when arrears are
increasing and collateral values are falling.
House prices and consumption
One important feedback is through the housing market which is continuing to weaken. The
number of loan approvals for house purchases is at a record low, the ratio of sales to stocks
is approaching the levels of the early 1990s, and prices are now down 12% on their peak of
late last year.
Of course falls in house prices tend to coincide with a slowdown in the wider economy
because they are affected by the same factors - notably falls in real income and
employment. But they can also feed back into activity. First they slow housing investment
and transaction flow which hits builders and related services like estate agents and
conveyancers. The purchases of white goods and furniture tend to go hand in hand with
transactions in the housing market. So the slowdown in the number of people moving home
is likely to impact on spending on those goods.
Falling house prices limit how much households and small businesses can borrow today and
that pulls down consumption and investment. Also by reducing their expectations of what
they will be able to borrow tomorrow either to compensate for a reduction in income or a
need to spend, some households and firms may increase their precautionary savings.
Finally, falling house prices redistribute wealth. Those who already own houses and expect
to trade down in future and realise a capital gain, are worse off. On the other side, those
hoping to trade up or who are not yet on the housing ladder are better off (although the
tighter constraints on lending may mean they have to save a bigger deposit to enter the
market). The former will tend to reduce their consumption; the latter will tend to do the
opposite. In a perfect market these two effects might balance out. But given that some of the
beneficiaries of house price falls do not yet have independent incomes, and others have a
longer period ahead to consume their additional wealth, on balance I would expect the net
effect on consumption to be negative. More widely I would expect some impact from the end
of a wide perception that in housing you can have your cake and eat it - that the return on
your house as an investment will in time substantially offset the cost of housing as a service.
All these feedback channels are at work and economics is better at identifying their nature
than in forecasting their scale. There is no alternative there to reviewing all the indicators I
have mentioned month by month and then making an informed judgment.
Some policy lessons for the medium term
We identified the mispricing of risk, particularly in credit markets in our Financial Stability
Reports
over the last two years. But the reckoning has been more severe and destabilising
than anyone anticipated. Risk premia had become compressed and leverage throughout the
financial markets had risen too high. The pendulum has now swung back with a vengeance.
As the FSR noted earlier this year, risk premia now appear to have overshot in some
markets and that is contributing to the slowdown in the real economy.
Could policymakers have taken earlier action to correct those imbalances? Of course we
took the decisions we did on the basis of the available data at the time. But with hindsight,
seen across the world as a whole, there was a case for somewhat tighter monetary policy to
prevent the demand for resources outstripping supply (although I would note that our interest
rates have been consistently higher in recent years than those elsewhere in the advanced
economies). The rise in oil and food prices has appeared as an external pressure on each
country on its own but it is not external to us all collectively. A particular problem here - that
has yet to be resolved - is the expansion of the dollar bloc. The emerging economies were
importing loose monetary policy, which scarcely seemed appropriate to their domestic
conditions.
However it is hard to believe that a somewhat tighter monetary policy would have been
guaranteed to head off the credit boom and subsequent crunch altogether. Put another way,
monetary policy is a blunt instrument. To prevent excesses in financial markets, we might
have had to generate an unnecessary slowdown in the real economy. I share the view
therefore that we have to look for new regulatory measures to complement interest rates.
There are a number of specific lessons on regulation which have already been identified. The
FSA, for example, is already strengthening its prudential supervision. And internationally, we
need to fill gaps in the current framework - for example on mortgage origination in the US,
increasing the capital requirements for some credit products and loan commitments, and
ensuring that investors and rating agencies assess new products more diligently. In the UK
we have also set out proposals to reform the legal framework for dealing with failing banks.
Through the Financial Stability Forum we also need to strengthened supervisory colleges
and cross-border crisis management arrangements.
One more general lesson is that we have to recognise the difference between what is good
risk management in a single company and what is good for the system as a whole. For a
company the ideal risk management system is one which enables them to take risks, reap
the rewards but get out first when the music stops. And the right capital and liquidity is one
which is just enough to see you through the subsequent downturn in asset prices and
transactions. But there is always someone at the end of the queue and it is impossible to be
sure who they will be. Moreover in a global market the problems of one institution are bound
to spread quickly to others along a complex web of interconnections in many markets. For
the authorities what matters is whether the losses to the slower players damage the system
as a whole. One lesson of recent events is that the capital and liquidity buffers need to be
higher for everyone. The long decline in holdings of liquid assets (Chart 8) by banks for
example has to be reversed a bit and the increase in leverage likewise (Chart 9).
In the Financial Stability Forum, which is leading the international regulatory response to the
crisis, we are also looking at the scope for "macro prudential" instruments to dampen the
destabilising procyclicality in financial markets. To do this we need to do more than simply
raise the minimum levels of capital and liquidity that regulators, rating agencies, or the
markets require. We need to create reserves based on macroeconomic factors, which can be
drawn down as the cycle turns down and have to be replenished on the upswing when profits
are high. The system of dynamic provisioning in Spain seems to work effectively in that
respect and may well offer a guide for the way forward.
Conclusion
To conclude, on monetary policy, we have one instrument, and one goal - ensuring that
inflation stabilises at target in the medium-term. While we must remain vigilant for any signs
of inflation expectations drifting upwards, the news on that front is encouraging. On the other
side, the risk we must be careful not to underestimate is the deflationary consequences of
the credit crisis.
At the moment we are focused on the risk that the slowdown in the real economy will be
amplified through a contraction in banks' balance sheets. But we should also set in place
longer term measures to prevent such financial imbalances from building up again in the next
upswing. In my view the case for macro-prudential policies alongside monetary policy is
compelling.
Chart 1: Commodity Prices Chart 2: CPI Inflation
Percentage points
Index: Jan. 2007 = 100
5
300
Energy
Brent oil price
Food and non-alcoholic beverages
4
Wholesale gas price 250
CPI (per cent)
Economist food-price index
3
200
150 2
100
1
50
0
0
-1
Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08
Chart 3: Inflation expectations Chart 4: Three month Libor spreads
Per cent
5
Basis points
5-10 years ahead 180
Sterling
[YouGov/Citigroup] 4
160
Euro
140
US dollar
3
120
100
2
80
12 months ahead 12 months ahead
60
[Bank NOP] [YouGov/Citigroup] 1
40
0
20
2003 2004 2005 2007 2008
0
Jan Mar May Jul Sep Nov Jan Mar May Jul Sep
2007 08 09
Chart 5: Credit conditions on mortgage Chart 6: Feedback effects (I)
lending
Net percentage balances(b)
Factors contributing to
Credit 60
changes in credit availability
availability
Changing Changing cost/
Weaker Weaker growth growth and and
40
economic availability of
falling falling house house (and (and other other
outlook funds collateral collateral ) ) values values
20
(3) (3)
+
0
-
20
Tighter Tighter credit credit
Bank Bank losses losses (1) (1)
40
conditions conditions (2) (2)
60
Q2 Q4 Q2 Q2 Q4 Q2 Q2 Q4 Q2
2007
2007 2007 08
Chart 7: Feedback effects (II)
Higher funding costs
Increase in Increase
Falling
Squeeze on net
Deterioration in the
loss given in credit
house prices
interest income
property market
default losses
Erosion of Regulatory
capital ratios minima
Macroeconomic
Increase
slowdown
Increase Pressure to
in default
in risk deleverage
weights
Scarring effect
Higher income
on capacity
gearing
Tighter credit conditions
Chart 8: Liquid assets ratio Chart 9: Leverage ratios of major UK banks
Per cent age of 35%
t ot al asset s
Maximum-minimum range Ratio
(all currencies)
Interquartile range 65
30%
Median
60
25%
55
50
20%
45
40
15%
35
10%
30
25
5%
20
0% 15
1967 1972 1977 1982 1987 1992 1997 2002 2007
10
Liquid asset s inclues: Cash, BoE balances, money at call, eligible bills and UK gilt s.
97 98 99 00 01 02 03 04 05 06 07 08
BIS Review 114/2008