Every six months the Bank of England publishes its Financial Stability Report. “It aims to identify the major downside risks to the UK financial system and thereby help financial firms, authorities and the wider public in managing and preparing for these risks.”
In the latest report, published on 17 December 2010, the Bank expresses concern about the UK’s exposure to problems overseas. The two most important problems are the continuing weaknesses of a number of banks and the difficulties of certain EU countries in repaying government bonds as they fall due and borrowing more capital at acceptable interest rates. As the report says:
Sovereign and banking system concerns have re-emerged in parts of Europe. The IMF and European authorities proposed a substantial package of support for Ireland. But market concerns spilled over to several other European countries. At the time of writing, contagion to the largest European banking systems has been limited. In this environment, it is important that resilience among UK banks has improved over the past year, including progress on refinancing debt and on raising capital buffers. But the United Kingdom is only partially insulated given the interconnectedness of European financial systems and the importance of their stability to global capital markets.
The Bank identifies a number of specific risks to the UK and global financial systems and examines various policy options for tackling them. The following articles consider the report.
Articles
Bank warns of eurozone risks to UK as EU leaders meet Independent, Sean O’Grady (17/12/10)
Deep potholes on the road to recovery Guardian, Nils Pratley (17/12/10)
It’s reassuring that regulators are still worried about financial stability The Telegraph, Tracy Corrigan (17/12/10)
Europe is still searching for stability and the UK must find it too Independent, Hamish McRae (17/12/10)
Shafts of light between the storm clouds The Economist blogs: ‘Blighty’ (17/12/10)
Report
Financial Stability Report, December 2010: Overview Bank of England
Financial Stability Report, December 2010: Links to rest of report Bank of England
Questions
- What are the most important financial risks facing (a) the UK; (b) eurozone countries?
- What is the significance of the rise in banks’ tier-1 capital ratios since 2007?
- Which is likely to be more serious over the coming months: banking weaknesses or sovereign debt? Explain.
- What is being done to reduce the risks of sovereign default?
- Why might the weaker EU countries struggle to achieve economic growth over the next two or three years?
- How do interest rates on government debt, as expressed by bond yields, compare with historical levels? What conclusions can you draw from this?
- What is likely to happen to bond yields in the USA, the UK and Germany over the coming months?
- What has been the effect of the extra £200 billion that the Bank of England injected into the banking system through its policy of quantitative easing?
The government’s plan for the UK economy is well known. Reduce the public-sector deficit to restore confidence and get the economy going again. The deficit will be reduced mainly by government spending cuts but also by tax increases, including a rise in VAT from 17.5% to 20% on 1 January 2011. Reductions in public-sector demand will be more than offset by a rise in private-sector demand.
But what if private-sector demand does not increase sufficiently? With a fall in government expenditure, reduced public-sector employment and higher taxes, the danger is that demand for private-sector output may actually fall. And this is not helped by a decline in both consumer and business confidence (see, for example, Nationwide Consumer Confidence Index). What is more, consumer borrowing has been falling (see Consumer borrowing falls again) as people seek to reduce their debt, fearing an uncertain future.
So does the government have a ‘Plan B’ to stimulate the economy if it seems to be moving back into recession? Or will it be ‘cuts, come what may’? The Financial Times (see link below) has revealed that senior civil servants have indeed been considering possible stimulus measures if a return to recession seems likely.
Over in Threadneedle Street, there has been a debate in the Bank of England’s Monetary Policy Committee over whether an additional round of quantitative easing may be necessary. So far, the MPC has rejected this approach, but one member, Adam Posen, has strongly advocated stimulating demand (see The UK inflation outlook if this time isn’t different, arguing that the current high inflation is the result of temporary cost-push factors and is not indicative of excessively strong demand.
So should there be a Plan B? And if so, what should it look like?
Articles
Gus O’Donnell’s economic ‘Plan B’ emerges BBC News, Nick Robinson (14/12/10)
Sir Gus O’Donnell asks ministers to consider possible stimulus measures Financial Times, Jim Pickard (14/12/10) (includes link to article by Philip Stephens)
Gus O’Donnell urges Treasury to prepare ‘Plan B’ for economy Guardian, Patrick Wintour and Nicholas Watt (14/12/10)
Unemployment, and that ‘Plan B’ BBC News blogs, Stephanomics, Stephanie Flanders (15/12/10)
Inflation wars (cont’d) BBC News blogs, Stephanomics, Stephanie Flanders (16/12/10)
Don’t overreact to UK inflation – Bank’s Posen Reuters, Patrick Graham (16/12/10)
Bank of England’s Adam Posen calls for more quantitative easing The Telegraph, Philip Aldrick and Emma Rowley (29/9/10)
Don’t overreact to above-target UK inflation rate, cautions Posen Herald Scotland, Ian McConnell (17/12/10)
Posen calls for calm as inflation fears rise Independent, Sean O’Grady (17/12/10)
Data
OECD Economic Outlook OECD (see, in particular, Tables 1, 18, 27, 28 and 32)
Forecasts for the UK economy HM Treasury
UK Economic Outlook PricewaterhouseCoopers
Employment and Unemployment ONS
Inflation Report Bank of England
Questions
- What are likely to be the most important factors in determining the level of aggregate demand in the coming months?
- What are the dangers of (a) not having a Plan B and (b) having and publishing a Plan B?
- Why is inflation currently above target? What is likely to happen to inflation over the coming months?
- What are the arguments for and against having another round of quantitative easing?
- What else could the Bank of England do to stimulate a flagging economy?
This week has seen the publications of two sets of forecasts on the UK housing market in 2011. The first of these came from Rightmove. It is forecasting that house prices next year could fall by as much as 5%. The extent of the fall though is argued to dependent, in part, on any rise in the Bank of England’s base rate and the number of properties taken into possession by lenders. These two factors are, of course, linked because higher debt-servicing costs can contribute to repossessions as the affordability of mortgages decrease. An increase in what are termed ‘forced sales’ will add to Rightmove’s general expectation of over-supply of property.
Righmove are expecting considerable local variations in house prices as a result of local demand and supply conditions. This makes forecasting a national average house price change extraordinarily difficult. It argues that the extent to which potential buyers are credit-constrained or to which demand is ‘credit crunch resistant’ varies across the country. This coupled with variations in the amount of supply to local markets will contribute to considerable differences in house price movements with house prices being ‘underpinned’ in some markets.
Rightmove is expecting the number of properties coming on to the housing market in 2011 to be around 1.2 million, 10% lower than in 2010. However, it is expecting only around 600,000 transactions which is close to half the historic average.
The second set of housing market forecasts this week was published by the Council of Mortgage Lenders (CML). The CML is forecasting that low interest rates will help to underpin current house price values with ‘flat or modestly falling house prices’. They argue that that while recent house price weakness will persist they ‘do not foresee any sharp fall in prices’. The CML are not expecting large numbers of buyers to hold off from looking to buy, but acknowledge there is uncertainty about the availability and cost of mortgage funding.
One contributing factor to the uncertainty surrounding the quantity and price of mortgages is the end to the Bank of England’s Special Liquidity Scheme (SLS). The SLS allowed banks to swap for a period of up to 3 years financial assets, such as mortgage-backed securities (a security representing a claim on the cash flows from mortgage loans), for UK Treasury Bills (short-term government debt). The scheme was designed to provide the banking system with liquidity. The last swaps will expire in January 2012. The CML reports that currently about £130 billion needs to be repaid by banks. More generally, of course, financial institutions are likely in 2011 to continue repairing and rebalancing their balance sheets and this is likely to impact on their lending decisions.
We noted how the Rightmove house price forecast for 2011 was partly dependent on those forced sales arising from repossessions. The CML is expecting what it terms a ‘modest increase’ in the number of possessions from around 36,000 this year to 40,000 next year. The CML though expects the number of transactions in 2011 to be a little higher than Rightmove, albeit still historically low at around 860,000.
All in all, activity levels in the housing and mortgage markets in 2011 are expected to be relatively subdued. This coupled with the expectation that house prices will be lower in 2011 suggests a very sober outlook indeed for the UK housing market. Happy New Year!
Articles
Lenders forecast flat house prices Financial Times, Norma Cohen (14/12/10)
UK mortgage lending to fall to 30-year low Telegraph, Steven Swinford (15/12/10)
Repossessions to rise in 2011, lenders forecast BBC News (15/12/10)
Market freeze: Homes sold once in 20 years Sky News, Hazel Baker (15/12/10)
U.K. mortgage lending may decline by a third in 2011 as weakness persists Bloomberg, Scott Hamilton (15/12/10)
House prices fall faster as estate agent predicts worse to come Telegraph, Ian Cowie (13/12/10)
Home sellers warned to drop asking price by 5% if they want to find a buyer Daily Mail, Becky Barrow (13/12/10)
U.K. home sellers may cut prices by as much as 5% in 2011 after December drop Bloomberg, Scott Hamilton (13/12/10)
Housing market forecasts
Rightmove’s housing market forecasts can be found within the December 2010 edition of its House Price Index
Rightmove December 2010 House Price Index (13/12/10)
CML publishes 2011 market forecasts CML News and Views, Issue 24 (15/12/10)
Questions
- Compare and contrast the Rightmove and CML house price forecasts for 2011. How similar are the stories underpinning their forecasts?
- What do you understand by forced sales? Using a demand-supply diagram explore how an increase in properties taken into possession could impact on house prices in 2011.
- What do you think affordability means in the context of housing? How might we measure this?
- What factors do you think might impact on the price and availability of mortgage finance in 2011?
- What do you understand to be the purpose of the Bank of England’s Special Liquidity Scheme. Using a demand-supply diagram explore how the termination of the scheme early in 2012 could impact on house prices in 2011.
- What do you think Rightmove means by ‘credit crunch resistant’ housing demand?
- Can demand-supply analysis help to explain how house prices pressure could vary from one area to another? Explain your answer using appropriate diagrams.
It is the Bank of England’s responsibility to ensure that inflation remains on target. They use interest rates and the money supply to keep inflation within a 1% band of the inflation target set by the government = 2%. However, for the past 12 months, we have had an inflation rate above the 3% maximum and this looks set to continue. Official figures show that the CPI inflation rate has risen to 3.3% in November, up from 3.2% in October 2010 – above the inflation target. There was also movement on the RPI from 4.5% to 4.7% during the same months. The ONS suggests that this increase is largely down to record increases in food, clothing and furniture prices: not the best news as Christmas approaches. It is not just consumers that are facing rising prices, as factories are also experiencing increasing costs of production, especially with the rising cost of crude oil (see A crude story). Interest rates have not changed, as policymakers believe prices will be ‘reined in’ before too long.
However, the government expects inflation to remain above target over the next year, especially with the approaching increase in VAT from 17.5% to 20%. As this tax is increased, retail prices will also rise and hence inflation is likely to remain high. There is also concern that retailers will use the increase in VAT to push through further price rises. A report by KPMG suggests that 60% of retailers intend not only to increase prices to cover the rise in VAT, but to increase prices over and above the VAT rise.
Despite the planned VAT rise spelling bad news for inflation, it could be the spending cuts that offset this. As next year brings a year of austerity through a decrease in public spending, this could deflate the economy and hence bring inflation back within target. However, there are suggestions that more quantitative easing may be on the cards in order to stimulate growth, if it appears to be slowing next year. The Bank of England’s Deputy Governor, Charles Bean said:
“It is certainly possible that we may well want to undertake a second round of quantitative easing if there is a clear sign that UK output growth and with it inflation prospects are slowing,” Bean told a business audience in London.”
The following articles consider the rising costs experienced by firms, the factors behind the inflation and some of the likely effects we may see over the coming months.
Articles
UK inflation rises to a surprise six-month high The Telegraph, Emma Rowley (14/12/10)
UK inflation rate rises to 3.3% in November BBC News (14/12/10)
Inflation unexpectedly hits 6-month high in November Reuters, David Milliken and Christina Fincher (14/12/10)
Food and clothing push up inflation Associated Press (14/12/10)
Retailers ‘to increase prices by more than VAT rise’ BBC News (14/12/10)
VAT increase ‘will hide price rises’ Guardian, Phillip Inman (14/12/10)
Slower growth may warrant more QE Reuters, Peter Griffiths and David Milliken (13/12/10)
Factories feel squeeze of inflation The Telegraph, Emma Rowley (13/12/10)
Figures show rise in input prices The Press Association (13/12/10)
November producer input prices up more than expected Reuters (13/12/10)
Data
Inflation ONS
Inflation Report Bank of England
Questions
- What is the difference between the RPI and CPI? How are each calculated?
- Why are interest rates the main tool for keeping inflation on target at 2%? How do they work?
- Is the inflation we are experiencing due to demand-pull or cost-push factors? Illustrate this on diagram. How are expectations relevant here?
- Explain why the rise in VAT next year may make inflation worse – use a diagram to help your explanation.
- Explain the process by which rising prices of crude oil affect manufacturers, retailers and hence the retail prices we see in shops.
- How are the inflation rate, the interest rate and the exchange rate linked? What could explain the pound jumping by ‘as much as 0.2pc against the dollar after the report’ was released?
- Explain why the public spending cuts next year may reduce inflation. Why might more quantitative easing be needed and how could this affect inflation in the coming months?
We have covered the issue of bank bonuses in previous blogs. See for example: Banking on bonuses? Not for much longer (November 2009); “We want our money back and we’re going to get it” (President Obama) (January 2010); and Payback time (Updated April 2010). But the issue has not been resolved. Despite public outrage around the world over the behaviour of banks that caused the credit crunch and about banks having to be bailed out with ‘taxpayers money’ and, as a result, people facing tax rises and cuts in public-sector services and jobs, bankers’ pay and bonuses are soaring once more. The individuals who caused the global economic crisis seem immune to the effects of their actions. But are things about to change?
The Committee of European Banking Supervisors (CEBS) has confirmed tough new guidelines on bank bonuses applying to all banks operating in the EU. The CEBS’s prime purpose in recommending restricting bonuses is to reduce the incentive for excessive and dangerous risk taking. As it states in paragraph 1 of the Guidelines on Remuneration Policies and Practices:
Whilst institutions’ remuneration policies were not the direct cause of this crisis, their drawbacks, nonetheless, contributed to its gravity and scale. It was generally recognized that excessive remuneration in the financial sector fuelled a risk appetite that was disproportionate to the loss-absorption capacity of institutions and of the financial sector as a whole.
The guidelines include deferring 40–60% of bonuses for three to five years; paying a maximum of 50% of bonuses in cash (the remainder having to be in shares); setting a maximum bonus level as a percentage of an individual’s basic pay; appointing remuneration committees that are truly independent; publishing the pay and bonuses of all senior managers and ‘risk takers’. Although they are only recommendations, it is expected that bank regulators across the EU will implement them in full.
So will they be effective in curbing the pay and bonuses of top bank staff? Will they curb excessive risk taking? Or will banks simply find ways around the regulations? The following articles discuss these issues
Articles
Bankers’ bonuses to face strict limits in Europe BBC News, Hugh Pym (10/12/10)
Bankers’ bonuses to face strict limits in Europe BBC News (10/12/10)
Europe set to link banking bonuses to basic salaries The Telegraph, Louise Armitstead (10/12/10)
Some bankers may escape EU cash bonus limit moneycontrol.com (India) (11/12/10)
Banks to sidestep bonus crackdown by raising salaries Guardian, Jill Treanor (10/12/10)
Bonuses: When bank jobs pay Guardian (11/12/10)
Bank bonuses (portal page) Financial Times
Committee of European Banking Supervisors (CEBS)
CEBS home page
CEBS has today published its Guidelines on Remuneration Policies and Practices (CP42) CEBS news release (10/12/10)
Guidelines on Remuneration Policies and Practices (10/12/10)
Questions
- What are main objectives of the CEBS guidelines?
- Assess the arguments used by the banking industry in criticising the guidelines.
- In what ways can the banks get around these new regulations (assuming the guidelines are accepted by EU banking regulators)?
- What conditions would have to met for a remuneration committee to be truly independent?
- How likely is it that countries outside the EU will adopt similar regulations? How could they be persuaded to do so?