Oil is back to $ a barrel (see Chart 2), while the Economist food index has fallen by over 30% (in dollar terms). Last week, we published our latest Inflation Report, laying out our current assessment of the outlook. It does not make for pleasant reading. Global demand fell sharply in the fourth quarter of 2008 and most forecasters expect a contraction in the advanced economies this year and negligible overall growth (see Chart 3). Here in the United Kingdom, GDP is estimated to have fallen by 1.5% in 2008 Q4. Business surveys point to a similar contraction in the first quarter of 2009. Household spending is declining. Investment intentions have fallen sharply. Credit availability has continued to worsen. And the four-quarter rate of growth of overall money spending in the economy has fallen to its lowest since 1959 (Chart 4). A sharp contraction in activity, both here and abroad, is already baked into the cake for the first half of this year. But there are grounds for thinking that conditions may start to improve later in the year, as there is a substantial economic stimulus already in the pipeline. First, since October, the MPC has cut Bank Rate by four percentage points to 1%, the lowest level in the Bank’s 315-year history. The dysfunctional credit markets mean that a given reduction in Bank Rate has less impact on the economy than in normal times. Even so, it still represents a powerful stimulus, which will take much of this year to work through.
This mix of exaggerated confidence and low real interest rates encouraged investors into riskier assets and banks into riskier lending, epitomised by the US sub-prime housing market. That was compounded by a lack of incentive for care in extending loans, if they were then packaged up and sold on to others. In August 2007, the economic weather turned distinctly autumnal. Falling US house prices and rising sub-prime defaults led to nervousness about the value of assets backed by those mortgages. Moreover, losses associated with sub-prime loans began appearing in places noone had anticipated, revealing how opaque many financial instruments were. The markets for these assets closed and their prices plummeted, putting pressure on the balance sheets of the financial institutions holding them, while wholesale funding dried up. And the wide dispersal of the suspect assets meant these balance sheet pressures were quickly transmitted internationally. In the United Kingdom, banks became increasingly cautious in lending, adding to downward pressure on housing and commercial property prices, and slowing growth. But at that stage, it was still possible to envisage a relatively modest slowdown, with financial intermediaries making the necessary balance sheet adjustments in an orderly fashion. However, the turmoil in credit markets was not the only factor the Bank’s Monetary Policy Committee had to contend with. Oil prices, already high at the start of 2008, hit $ a barrel in July, while a broad range of other commodity prices rose sharply.