Market commentary
21 May 2008
The Bank acts
The Bank announced its Special Liquidity Scheme (SLS) on April 21.
The primary aims of this are to improve the liquidity of banks and to lower the current high level of wholesale money rates relative to Bank rate.
The scheme is open to participants of the Bank's Standing Facilities. This covers the larger deposit taking institutions, but excludes some lenders who are solely wholesale funded as well as some smaller building societies. While the Bank initially expected take up to total around £50 billion, there is no set limit.
For a fee, qualifying lenders are eligible to swap some of their less liquid assets, including high quality residential mortgage backed securities (RMBS), for more easily tradable Treasury Bills. The initial swap period is one year, but it can be extended for a further two years at the Bank's discretion.
The SLS is only likely to take effect slowly, and in conjunction with the further disclosure and writing down of impaired and illiquid assets (and repairs to bank balance sheets and capital ratios). It is not aimed specifically at the mortgage market and it is likely to be some time before there is a measurable benefit to the availability of mortgage credit.
The spread between 3-month Libor and Bank rate fell by around 0.2% following the announcement of the SLS, but it has widened a little in the last week. The current spread of 0.85% compares with a range of between 0.2% and 0.3% just prior to the credit crunch. This suggests the SLS has had little impact on interbank liquidity so far.
Chart 1: Bank rate vs 3-month Libor
Source: Bank of England, BBA
But room for manoeuvre is limited
The SLS may have helped address the worst uncertainties of the credit crunch, but the impact of the credit crunch on the wider economy has only been partly felt so far.
The central projection in the Bank of England's latest Inflation Report shows economic growth slowing from 2.5% in the first quarter of this year to around 1% by the end of this year. This will be the slowest rate since 1992 and is slow enough to see employment fall and unemployment rise.
But the Bank's room for manoeuvre to support the economy is severely constrained by inflation. The target measure hit 3% in April - a full 1% above target - and is expected to rise further this year, to a peak of around 3.7% in the third quarter. It is not expected to fall back to the 2% target until towards the end of 2010.
The Governor made clear that there will be no rush to drive inflation back to target immediately - for example by raising interest rates - as "to try to bring CPI inflation back to target within this period would result in an undesirable degree of volatility in output, so the MPC is aiming to bring inflation back to target over a somewhat longer horizon".
The Inflation Report stressed that the Bank remains committed to its remit to bring inflation back to the target level over the medium term. This means that interest rates are likely to continue to bear down on economic activity for the foreseeable future. But it does not rule out one or two further small cuts in Bank rate over the coming year.
After a decade of benefiting from falling import prices, which have helped offset a higher level of domestically generated inflation, we now face the prospect of import price inflation rising faster than the inflation target. This will require domestically generated inflation to be below 2%.
CML market forecasts
Latest data show housing and mortgage market activity continuing to soften.
House prices are now 4% to 5% lower than their peak levels last summer and house sales in recent months have been sharply lower than a year earlier.
The timing of Easter has distorted recent monthly gross lending data, but taking March and April together, we estimate that lending was 16% lower than in the same period a year ago.
The outlook for lending for house purchase remains difficult. The latest figures for mortgage approvals for house purchase show a drop of more than 40% from a year ago. This is likely to mean that lending volumes will fall further in the coming months.
Remortgaging activity will be stronger, with the anticipated wave of maturing deals coming through, although, here, too, funding constraints have resulted in a tightening of lending criteria. This means that remortgaging is either not available, or not as attractive as in the past, for a larger number of borrowers, notably those with adverse credit histories and high loan-to-value ratios.
Chart 2: House purchase and remortgage approvals (seasonally adjusted)
Source: Bank of England
We published our updated forecasts today.
We expect the next few months to remain difficult, and for mortgage approvals for house purchase to fall further. Downward pressure on house prices is unlikely to abate until there is an increase in mortgage approvals for house purchase driven by strengthening demand.
Beyond that, the Bank's SLS should start to free up liquidity, some of which could be recycled into the mortgage market and this might help support lending towards the end of the year.
Gross lending is expected to be £285 billion this year compared with £363 billion in 2007. Net lending is expected to be £55 billion, down from £108 billion last year. House prices are expected to fall 7% in the year to the fourth quarter. The volume of housing transactions will fall around 35%.
Economics team
- Paul Samter
- Jim Cunningham
- Bob Pannell
