Economy set to suffer

July saw record mortgage lending, and other good economic indicators such as increased tax revenues and a buoyant growth in money supply. Surely the economy is doing well, despite five interest rate rises over the last year, and the recent turbulence in global stock markets.

The economy has been on an upward trend for 15 years and some of these underlying figures suggest that it could continue. However, the world-wide squeeze on credit may have a longer lasting and deeper impact than feared, and City analysts are beginning to believe that economic figures for August will show signs of a significant slowdown.

One major are of concern is the housing market. Lending standards have slipped, demand remains high, bolstered by an influx of foreign workers, and house prices have kept growing on average faster than average incomes have gone up.

The Council of Mortgage Lenders reported that gross mortgage lending reached a record of £34.4bn in July. The Bank of England warned recently that the UK has £1.3 trillion mountain of debt which has left the economy vulnerable to a change in financial conditions. ‘Perhaps the biggest risk to the outlook for domestic demand’ was the way the Bank’s Inflation report in August described household debt.

Well, guess what! Financial conditions have changed in the last couple of weeks. The stock market has been in turmoil seeing huge falls one day and almost – but not quite – as high rises a day or two later.  The FTSE 100 index has lost ten percent in the last month.

Additionally, with the Bank’s base interest rate at 5.75% – its highest level since March 2001 – and the banks’ swap rate is even higher, the cost of money is higher than for nearly a decade. The Bank of England has not reacted like the Federal Reserve did in the United States, where it provided cheap liquidity to help steer the inter-bank rate to lower levels, however, the Bank would be able to do so if pressed.

The problem for consumers is that lenders may eventually have to pass on the increasing cost of credit to its customers. This may be followed by a dropping of interest rates by the Bank of England in order to give the economy a boost. While this may seem good news for homeowners, the tightening of credit and worsening financial conditions are not good for economic growth.

It is a complicated scenario for borrowers. Some areas of the mortgage market are experiencing tighter credit conditions, but some borrowers should benefit. The cost of some fixed rate mortgage has already started to come down in August. The reason for this is that rates are linked to the government gilts’ yields, and these have fallen sharply. For other borrowers, particularly those in the sub-prime category, the outlook is bleak. It was lending to this category by investment banks in the US that is the route of the current worldwide financial crisis. Funds based on this lending have collapsed in value as sub-prime borrowers have defaulted on mortgages. Many funds and banks have borrowed against this sub-prime market and passed on the repackaged funds to others. With those funds now worthless, banks have tightened their lending criteria with the result that the financial markets have gone haywire. Raising finance for similar products in the UK is now extremely difficult.

Many companies have raised their rates, or tightened their lending criteria or withdrawn their entire sub-prime product range in the last few days. Chris Rayner of The Mortgage House said: “It will people with the worst adverse credit who will suffer most. Their interest rates will increase the most, or in some extreme cases, they won’t be able to get a mortgage at all.”

Across the UK as a whole, sub-prime does not represent a large part of the market, so the wider impact is not likely to be significant. However, Simon Rubinsohn of the Royal Institution of Chartered Surveyors (RICS) says that lenders are likely to tighten standards across the board, which might mean, for example, a reduction in loan-to-value ratios or getting more stringent with customers looking for buy-to-let mortgages.

In the circumstances of the stock market plunge, City activity is likely to cool, and there is little doubt that there will some evidence of an economic slowdown.

Rubinsohn said: “’Let’s say the global economy slows, and the labour market has a shake-up. It would be foolish to say there wouldn’t be quite significant consequences for the UK housing market.”

The Bank of Egnland’s Monetary Policy Committee must have had at the back of its mind a fear that continual increases in the base rate would eventually have and adverse effect on the country’s economy. Rather like the rest of us feel as individuals when high finance impacts on our lives, they must be frustrated that the actions of banks in the US have pulled the rug from under their feet.