Jeremy Warner's Outlook: Coming to terms with sluggish growth

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The Independent Online

More on the credit crunch later, but just for the moment stepping back from the arcane world of structured investment vehicles, conduits, three-month interbank interest rates and so on, what's going on in the real economy?

Unusually, the Bank of England yesterday issued a statement to explain its decision to leave interest rates on hold, but only for the purpose of stressing that in fact the turmoil in financial markets had had very little influence on deliberations. Instead, the decision was taken solely on the basis of the outlook for inflation and growth. It was still too early to tell what impact the credit crunch would have, if any.

The prospect of an interest rate rise at yesterday's meeting had in fact been effectively taken off the agenda long before the full enormity of the present liquidity crisis became apparent. Inflation for July had unexpectedly come in below target, and seemed destined to remain so for some months to come. This removed the immediate need for further tighening. By contrast, the coincidental decision by the European Central Bank yesterday to leave rates on hold plainly was influenced by conditions in the credit markets. Only last month, the ECB president, Jean-Claude Trichet, put the markets on notice of a rise in rates. The high level of uncertainty in financial markets has caused him to reverse that position.

British policymakers seem to be made of altogether sterner stuff. Yesterday's statement, though not overtly hawkish, noted grimly that "indicators of pricing pressure remain somewhat elevated". Even in the panicked City, few are yet prepared entirely to rule out a further rise in base rate by the end of the year.

The same OECD forecasts which this week warned that the US economy may be slipping towards recession saw Britain's predicted rate of growth for this year raised to 3 per cent. This would make the UK again the strongest growing economy in the G7. Yet at the coal face of consumer confidence and spending, business leaders are not so sure.

I've spoken to a number of major retailers this week and on one thing they all agree; it's been a ghastly summer which has forced most of them into early sales and deep price discounting. What is not clear is the degree to which this was caused by the lousy weather. It has become a cliché for retailers to blame their travails on the weather, yet this summer, for once, they may have a point. The unsold barbecues and summer frocks are still stacked high. All the same, there is likely something more fundamental happening too.

Rising prices, taxes, and interest rates are causing disposable incomes to be squeezed at a time when British consumers have surely reached the upper limits of their capacity to borrow. One retailer is planning for a shrinkage in the amounts consumers have for discretionary spending – that is what's left after essential spending on bills, mortgages and so on – from around 28 per cent of disposable income this year to 21 per cent next That's quite a drop.

This doesn't necessarily mean all retailers will suffer together. The better ones should continue to thrive. But it does mean the consumer environment is going to become a whole lot tougher. Worse still, notwithstanding yesterday's decision and the turmoil in financial markets, interest rates may be moving on to a permanently higher footing, threatening the easy gains in the housing market of recent years.

By hugely expanding the pool of cheap labour available to the global economy, rapid development in Asia has so far been a disinflationary influence. But that's now changing as domestic demand in China and India picks up. We already see the effects in fast inflating food and commodity prices. Pressure for ethically and environmentally friendly produce further reinforces the idea that the age of cheap food, clothing, cars and electronics may be drawing to a close.

None of this will completely derail the British economy. Even so, growth is likely to become more sluggish. The years of plenty may be drawing to a close.

Call to bankers: bring out your losses

In an attempt to restore investor confidence, Josef Ackermann, chief executive of Deutsche Bank, has urged bankers to come clean about the extent of their losses from the present credit crunch. This would obviously be a welcome development, but the idea suffers from one rather major flaw; as yet, nobody has any idea what they might be. Those who have attempted to quantify the losses are doing no more than sticking a finger in the wind.

One of the latest attempts to calm markets comes from Citibank, which said yesterday with regard to the seven structured investment vehicles (SIVs) it runs that the credit quality of their assets remained strong. The bank's words sound reassuring but mean absolutely nothing. The reason the SIVs and conduits operated by banks have been unable to refinance themselves in the commercial paper market as loans fall due is that nobody trusts the underlying assets, notwithstanding what the credit rating agencies and sponsoring banks say about their value.

Even pure, sub-prime mortgage-backed securities must be worth something, yet as things stand they are impossible to sell, so on a mark-to-market basis are essentially valueless.

If these assets cannot be refinanced in the commercial paper markets, lenders to the SIVs and conduits are eventually going to have to take a haircut. Either that, or take the underlying assets directly back on to their own books. And if the assets cannot be sold, what price is going to be assigned to them? Hardly anyone pretends to have answers, which is why the money markets have seized up.

Nor are these the only unanswered questions raised by the present mess. Are conduits taken into account in the related bank's credit rating? If it is true that many of them are off balance sheet and unregulated, how if at all are their activities monitored and assessed for the purpose of prudential supervision?

It is not just the Bank of England that has been largely silent throughout the summer crisis, the Financial Services Authority has said nothing either. Both of them have been warning for years about the risks posed by the build-up of collateralised debt obligations and other synthetically constructed debt instruments, but they did nothing to check the growth of these markets and, now that it has all blown up in their faces, they seem at a loss to know what to do about it.

Apologists for their position would argue that you cannot have wealth creation without risk, and it is not the job of a regulator to prevent the markets from running such risks, however extreme they might be. What's more, the financial system needs the occasional crisis to purge itself of its excesses. The process is necessary and cathartic. Nobody of any significance has yet gone bust, depositors' money is safe and, though credit conditions are tightening, there is no evidence of more lasting damage.

A less kind way of looking at events is that the markets have run rings round the regulators, and, in their hunger to make fat profits, put the whole economy at risk. It may be some months before we know which of these views better reflects the truth. Meanwhile, the two banks under most pressure to "come clean" over their exposure are the ones in the midst of the battle for control of ABN Amro – Barclays and Royal Bank of Scotland.

The turmoil in credit markets has eclipsed interest in this tussle, yet the bids are still on the table. No assessment of the relative merits of the two bids can be made in the present state of unknowing about banking profits and balance sheets. Shareholders in both banks are going to take some convincing that it is worth persisting with these acquisition plans in current conditions. We need to know where the bodies are buried first.