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Economics Week: What has been the impact of the credit crisis on the UK economy?; Weekly economic data preview: The Bank of England's Quarterly Inflation Report and key UK and US economic data are due

Economics Weekly  12 November 2007


What has been the impact of the credit crisis on the UK economy?


How has the global credit crisis impacted the UK and global economy?

What impact is the credit crisis having on the global and UK economy, if any? That is the subject of this weekly. This question can be examined first in terms of the financial market effect and second in terms of the impact on the real economy.


Impact of credit crisis on financial markets is mixed

In terms of the impact of the credit markets on financial markets generally, it is clear that spreads in the credit market are still wide, even though they have improved markedly since the worst of the crisis in August. However, they have not, and are unlikely, to return to pre-August trading patterns as those were periods of chronic underpricing of the riskiness of these instruments. Generally, equity markets have recovered since their lows and are higher than pre-August levels, even though there is still a lot of volatility.


In the UK, the equity market, using the FTSE 100 as an example, is up 50 points since 1 August. Longer term government bond yields have fallen in most markets and are down from 5.20% in the UK on 1 August to 4.75% in November, easing borrowing conditions for firms. Also lower is the UK 10-year swap rate, which influences the rate of bank loans to large companies, and was down by 57 basis points (tenths of a percentage point) to 5.59% on 7 November (see chart a). However, the cost of mortgage borrowing for households has gone up by 24 basis points, from 7.51% on 1 August to 7.75% in November (see chart b). Banks with exposure to asset-backed securities have released more details about their losses and some activity has returned to credit markets, but trading conditions remain fragile.


The excess of money market rates over base rates (the cost of borrowing from the central bank) remains exceptionally high, see chart c, and well above five year averages. From the chart it can be seen that, for the UK, the spread of bank borrowing over the central bank benchmark rate is 53 basis points compared with a five year average of 20. The gap for the US is 40 compared with 23 and for the eurozone it is 58 compared with 20. If not for the cut in US short term interest rates of three-quarters of one percent since September it is likely that the spread there would be even higher, given that the US is at the epicentre of the crisis.


But volatility in credit markets is still likely to continue for many months yet, as not all of the news

about potential losses and positions in more complex securities has been released and so credit markets will remain open to further shocks as new information emerges. Surveys by central banks in the US, UK and eurozone all show that banks are tightening credit standards or planning to, which will raise borrowing costs and lower the supply of credit. However, the planned tightening of credit standards in the UK is relatively mild, though more so for companies than for households, according to a recent Bank of England survey.


So, what does all of this mean for the real economy? The fear is that the credit crisis will impact the real economy because of the importance of the financial sector in generating economic growth and as higher borrowing costs are passed on to households and companies. That would lead them to borrow and spend less and so weaken overall economic growth. If that is the logic then there are few signs of this at present and the few there are seem more related to earlier increases in interest rates than to the credit crisis.


What has happened to consumer confidence, economic growth and the company sector since August? Evidence suggests that consumer confidence has barely budged since August, down only a point or so. Despite worry that after the run on Northern Rock that there would be a severe loss of confidence amongst households, mortgage borrowing has risen and so has consumer credit. In September, net lending secured on dwellings was £9.8bn, up from £8.3bn in August and net consumer credit rose £1.4bn, up from £0.8bn in August.


Economic growth in the UK was 0.8% in Q3, up 3.3% on the year. But growth was not just up in the UK, it was up by 0.9% in the US in the quarter and by 3.9% on an annualised basis; and was also up firmly in the eurozone in Q2, see chart d. This is not to say that growth will not weaken in Q4, but it has held up well so far this year. In fact, we do look for some slowdown in the coming three months, but surveys of company activity and data for actual output also suggest that although there has been some softening, there is no recession type contraction on the way. This may be why the US is the only major economy that has cut interest rates. Switzerland, Sweden and Australia, for example, have raised rates since the credit crisis broke in August.


The ECB is signalling that with higher oil prices, strong growth in its money supply and a rise in inflation to 2.6% in September, it is mindful to raise rates. The Bank of England has kept UK rates on hold in November, and comments from MPC members have been suggesting that a cut is not likely until the economy has clearly started to slow to a trend – around or so 2.5% annual - pace of growth. They cite high oil prices, rising food prices, and an enhanced ability by companies to pass on price rises to customers in an environment of above trend economic growth and rapid expansion in money supply as their key inflation concerns.


In summary, it is not clear what the final outcome of the credit crisis will be on the real economy. So far evidence suggests that the impact is quite mild, but it may not remain so, especially for the US economy. But the rest of the world is growing quickly. In the last few years, the emerging markets have been providing the majority of the impetus to global growth. This may be a mitigating factor in any credit induced economic slowdown insofar as the credit crisis mainly impacts the major economies. The effect of the credit crisis on the emerging market economies directly or indirectly so far has been insignificant. But the problem is that it is possible to see how it could impact more severely. Therefore, until the full extent of the credit crisis is known and absorbed, it will remain a big potential threat to economic growth.

Trevor Williams, Chief Economist


Weekly economic data preview


The Bank of England's Quarterly Inflation Report and key UK and US economic data are due this week


While markets will continue to focus on news of write-downs on mortgage-related securities, they will also be occupied with a heavy week of UK and US economic data releases and reports, potentially leading to more volatility and sharp price movements. This includes the Bank of England's Quarterly Inflation Report, which will provide market analysts with crucial information about the Bank's thinking on economic growth and inflation over its two year forecast horizon. In terms of UK data, producer prices, CPI & RPI inflation, labour market data and retail sales, will all offer crucial information to form views on the appropriate interest rate framework. Also this week, the US publishes producer prices, retail sales, CPI inflation, Treasury International Capital Data (TICS), industrial production and capacity usage. Japan may publish a gdp growth outcome of 1.7% annualised for Q3 on Monday, but the BoJ is unlikely to use this to raise interest rates from 0.5% at its policy meeting early Tuesday morning, because of deflation. The communiqué of the G20 finance ministers and central bank governors' meeting in Cape Town (18th & 19th) may attract some attention.


• The BoE's November Inflation Report, published Wednesday, follows the MPC's widely expected decision to hold rates at 5.75% last Thursday. It also comes at a critical time for the UK economy as concern rises that oil prices close to $100 a barrel and significantly higher agricultural commodity prices could spill over into CPI inflation. The report may show the risk to inflation is on the upside, which may prevent the Bank from cutting interest rates until there are clear signs of slower economic growth.


• On Tuesday, UK economic data may show that CPI inflation could edge up closer to the 2% target; from 1.8% in September to 1.9% in October. The RPI measure, the benchmark rate for wage negotiations, could increase from 3.9% to 4.1%. Wages growth on a 3-month rolling average basis may have risen to 3.9% in September from 3.7% in August, published Wednesday.


Other labour market data will show that claimant count unemployment fell for the thirteenth consecutive month in October, showing that the UK jobs market is healthy. However, firms' margins may start to feel the pressure of a 1.5% rise in input prices on a monthly basis in October, 7% on the year, price data due on Monday. On Thursday, a weaker BRC retail survey suggested that monthly retail sales growth may have slowed to 0.3% in October, though this translates into a strong rise of 5% annually.


US data are likely to support Fed Chairman Bernanke's view that inflation remains a risk to the US economy. On Wednesday, affected by higher oil prices, US producer prices in October could come in 6.3% higher on the year, compared with 4.4% in September, the highest rate in two years. Consumer price inflation, published Thursday, may have risen 3.5% on the year, up from 2.8% a month earlier. Core inflation, which excludes energy and food, may have edged up to 2.2% annually from 2.1%. We are expecting strong October retail sales and a rise in industrial production and capacity use, but positive incoming data may do little to support the dollar as the Fed's and the market's view is that gdp growth in Q4 slowed. The November Empire manufacturing and Philadelphia Fed surveys may come in weaker. On Friday, markets are looking for a rebound in TICS capital inflows to $80bn in September following a $69.3bn outflow in August.


• The ECB maintained the base level of official interest rates at 4% on Thursday and ECB President Trichet re-iterated his inflation concerns suggesting a bias towards raising rates once confidence is restored in credit and money markets. On Wednesday, EU-13 Q3 GDP may have risen 0.6% on the quarter, 2.5% on the year, with Germany making a strong contribution. However, the ZEW survey for November due Tuesday could fall further from -18.1 to -20, partly due to continued investor concern about liquidity in credit markets and the economic implications of the strong euro exchange rate.

Nichola James, Senior Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.



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