Bank of England steps in...

UK Weekly, Sep 14, 2007

* On 14 September the Bank of England announced it was providing emergency liquidity support to Northern Rock, one of the UK's largest mortgage lenders. This support was aimed at helping Northern Rock overcome funding problems resulting from the recent sharp rise in interbank lending rates; Northern Rock had been heavily reliant on wholesale markets - rather than deposits - to fund its mortgage lending, a source of funds that had dried up as a result of banks' recent moves to hoard cash and reduce lending to each other. The difficulties Northern Rock was experiencing were hinted at last month when it raised the cost of subprime mortgages sharply.

...while warning against moral hazard

* The size of the Bank of England's liquidity loan to Northern Rock has not been revealed, but it is known that the facility is being provided at a penalty rate, and is limited by available collateral - likely to be the lender's mortgage book. As such, this bail-out broadly squares with the philosophy the BoE outlined in a special statement released on 12 September, which warned against providing ex-post insurance for risky behaviour.

* In the BoE statement, BoE Governor King noted the problems being caused for banks by the need to absorb onto their balance sheets the assets of off-balance sheet investment vehicles and assets such as syndicated loans originally intended for on-sale to end investors.

* However, King argued that the banking sector was well capitalised and thus should be able to manage this problem. Moreover, he made a strong defence of the different approach the BoE has adopted in recent weeks compared to the Fed and the ECB. He argued that current market turmoil reflected a correction of a prior 'mispricing of risk', and that offering special liquidity support to banks would penalise more prudent institutions and perhaps encourage excessive risk-taking - sowing the seeds of future crises. The economic costs of the current crisis would have to be large, in King's view, to override this risk of moral hazard.

King hints policy could shift...

* King's statement did acknowledge a potential wider economic impact from the current liquidity problems, via a possible rise in corporate borrowing costs or a cutback in lending by banks. He also noted that 'interest rates are a flexible tool that can be adjusted quickly when necessary'. However, he argued that the August Inflation Report had implied that some slowdown in growth was needed to keep inflation on target. Overall, the tone of the statement suggests that the economic picture will have to darken significantly for the BoE to consider actually easing policy- but there was perhaps just a hint here that rates might have peaked.

* That said, the BoE has made an additional technical move to ease the strains in the money market - by relaxing the requirement for banks' to keep a target balance at the BoE at the end of each day. Previously, banks were obliged to keep within /-1% of the target balance, but may now be within /-37.5%. The intention here may be to prevent a rerun of a recent incident where a major clearer had some problems meeting its target. In the current environment, the BoE may be concerned that such incidents might cause unnecessary disquiet among the public.

...but mortgage rates on the rise

* Meanwhile, the liquidity problems in the money markets are beginning to feed through to mortgages. The elevated level of interbank rates is putting pressure on lenders who have funded their lending via borrowing in the wholesale market an increasing practice in recent years. On 12 September, Abbey announced it was raising rates on its 'tracker' mortgages by 0.1-0.2% as a result of this, with Standard Life and Halifax set to follow suit. These rises come on top of a rise in mortgage rates of up to 25bp in August - partly the result of the July BoE hike. The standard variable rate is now at its highest level since late 1998.

Latest data in detail

Producer prices steady

Producer input prices fell by 0.5% in the month to August compared to a 0.8% monthly decline in July; the main cause was a fall in the price of oil and metals. On an annual basis, input price inflation remained constant at 2.5%. Output price inflation rose by 0.2% points to 2.5% in August. Annual core output price inflation also increased slightly in August to 2.4%, up from 2.2% in July.

Trade deficit worsens

The UK's trade position worsened significantly in July. The visible trade deficit increased to £7.07bn from £6.27bn in June. The deterioration stemmed from a widening of the oil balance to a deficit of £0.27bn, the largest gap since January. The trade gap with non-EU countries increased from £3.39bn to £4.48bn. However strong demand from the EU - the UK's main trading partner - was able to offset some of the widening as the trade gap with the EU narrowed from £3.15bn to £2.59bn.

Labour market tightens

The labour market showed further signs of tightening in July, with the number of people claiming unemployment benefits falling by 4,500 workers. The claimant count fell from 2.7% in June to 2.6%, its lowest since April 2005. The ILO measure of unemployment remained constant at 5.4%. Annual average earnings growth in the three months to July rose slightly to 3.5% from 3.3% in June, but still remains below the 2006 average of 4.0%. Private sector salaries out-paced public sector wage increases, with growth of 3.7% and 2.7% respectively.