The following is an unedited transcript of the news release from the Bank of England.


Financial markets

Sentiment in international credit and money markets appeared to have deteriorated over the month. Term interbank spreads had risen in the US and UK money markets, probably reflecting heightened concerns about counterparty credit risk. Conditions in primary markets for securitised assets remained difficult and there had been a general widening of spreads on asset-backed securities (ABS). Spreads on US and UK investment-grade corporate bonds had risen sharply. Spreads had also risen in the US municipal bond market.

It was difficult to pinpoint the precise reasons for this change. The recent financial reporting season for European banks had not produced any major unexpected losses or problems with reported capital buffers. There had been some encouraging news about the possible recapitalisation of the major non-bank financial guarantors (the ‘monolines’). However, as various asset prices fell, highly leveraged borrowers were being forced to sell assets in the face of increased margin calls, there by possibly amplifying the downward movement in asset prices. That further encouraged lenders to try to reduce overall exposures to such borrowers. These concerns had probably been heightened by developments in the US municipal bond market and the failure of the Peloton Partners ABS hedge fund in the United Kingdom. Increasing default rates on US mortgages had brought into question the quality of securitised mortgages with higher credit ratings than those in the sub-prime category. The continuing uncertainty about where asset prices would settle was discouraging potential investors from
buying, not least because they might fear posting substantial mark-to-market losses in the short run.

International market interest rates had risen over the month, with forward rates for the end of 2008 some 10 to 20 basis points higher, perhaps reflecting a growing awareness of upside risks to inflation and central banks’ likely reaction to them. Longer-term forward rates had also risen, although, perhaps surprisingly, these increases had been associated with rises in long-term risk-free real interest rates, which might have been expected to fall, given the apparent ‘flight to quality’ in bond markets. As for inflation break-even rates, these had increased noticeably on the month only in the euro area, and only at horizons under five years and over fifteen.

Equity prices ended the month broadly unchanged, as earlier gains had been lost over the few days prior to the MPC meeting. The comparative resilience of equity markets had been surprising, given that market interest rates had risen. Investment analysts’ earnings expectations had been revised downward, and spreads on corporate bonds had widened sharply, reflecting increased risk aversion and/or perceptions of increased corporate credit risk. However, non-financial corporate default rates had not yet picked up significantly.

The major news in the foreign exchange markets had been the continued fall of the US dollar, for which the effective exchange rate index was some 3% lower than a month earlier. The euro effective rate had appreciated by around 2%, while the sterling effective rate had fallen around 1½% over the month. These movements appeared to be broadly consistent with conjunctural developments and expectations of larger cuts in US and UK policy rates than in the euro-area rate. Options prices suggested that market participants believed that movements in sterling had become more closely correlated with the dollar and, possibly to some extent reflecting that, the risks to the sterling effective exchange rate were skewed to the downside.

The international economy

For the United States, the main question was how long the current downturn would last and how deep it would be. There had been little news in the latest estimate for growth in the fourth quarter of 2007, which was unchanged from the previous release at 0.2%. Data for the first quarter of 2008 so far suggested that growth had been subdued. On the output side, industrial production had risen slightly in January but the Institute for Supply Management (ISM) index for manufacturing for February had fallen to a little below the 50 no-change level. The ISM non-manufacturing index had rebounded in February to just above the 50 level from a very low January reading, but had remained well below its historical average. Expenditure indicators were also lacklustre. The Federal Reserve’s Beige Book suggested that the slowdown was now broadly based by industry sector and region. Bank lending to the US corporate sector remained robust, but that might reflect the drawing down of credit lines agreed before the deterioration in credit market conditions last August and the inability of banks to sell on corporate loans. Data on both activity and prices suggested that the US housing market had continued to weaken. Despite the fall in the federal funds rate, some households were facing higher interest rates. Consumer confidence measures had fallen further in February, with the Michigan measure hitting a 16-year low. Meanwhile, indicators of inflation had risen. Annual producer price inflation had reached 7.4% in January, while headline inflation according to the personal consumption expenditure deflator and CPI had increased to 3.7% and 4.3% respectively.

In the euro area, data on the expenditure components of GDP in the fourth quarter had suggested that consumption had been surprisingly weak. Activity indicators for the first quarter were in line with the expectations embodied in the February Inflation Report. The February services and manufacturing Purchasing Managers’ Index measures, for example, were both consistent with positive, but belowtrend, growth. The European Commission’s surveys of business confidence in the industrial and services sectors painted a similar picture. Lending to the corporate sector appeared to be holding up, and it was less clear that euro-area banks as a whole had had the same experience as US banks with ‘stuck’ loans and committed credit lines. As in the United States, producer price inflation had increased, reaching 4.9% in January. HICP inflation remained at 3.2% in February, above the level deemed by the European Central Bank to be consistent with price stability.

In Asia, the estimate of Japanese GDP growth in Q4 had been 0.9%, markedly stronger than expected. However, Japanese GDP data were often revised substantially. Industrial production was reported to have fallen 1.9% in January, but export growth had held up. Growth in the fourth quarter in non-Japan Asia had also been somewhat higher than expected at the time of the February Inflation Report. China posted an annual growth rate of 11.2% and was showing signs of increasing inflationary pressures. Annual producer price inflation had risen to 6.1% in January and annualconsumer price inflation hit an eleven-year high of 7.1%.

World commodity prices had continued to rise rapidly over the month. The price of Brent crude, for example, had reached a new high, increasing by 12% in sterling terms. A range of factors were responsible, with the importance of each factor varying by commodity. Some of the price increases would affect consumer prices rapidly, while others might take a long time to work through the supply chain. It seemed unlikely that these inflationary pressures would abate soon, despite the slowdown in advanced economies. First, demand for commodities from emerging markets, particularly in Asia, was likely to continue to increase rapidly. For example, many of these economies still had much lower energy use per head than did OECD countries, and some degree of convergence with advanced economies was to be expected as the gap between levels of GDP per head narrowed. Second, OPEC did not seem inclined to increase oil production quotas. Third, in several emerging-market economies, price subsidies continued to dampen any reduction in demand. Fourth, it was possible that commodities had become a more attractive asset class to both financial intermediaries and ultimate investors, perhaps partly as a hedge against a weakening US dollar and partly because of the current
problems in advanced economies’ credit markets. Greater involvement of financial firms might also affect the dynamics of commodity prices in the short run.

Money, credit, demand and output

The ONS UK Output, Income and Expenditure data release had contained an unchanged estimate of 0.6% for the Q4 GDP growth rate. On the output side, there had been some small downward revisions to estimated growth in both services and manufacturing. However, the first release of expenditure data had showed consumption growth slowing sharply to 0.2% and business investment contracting by 0.5%, implying the weakest growth in final domestic demand for five years. The contribution from net trade had increased, and the annual growth rate of stocks in 2007 was the fastest since 1973. Overall growth had been only a little lower than in the third quarter, although private sector output had slowed by more.

These data raised the possibility that there had been a sharp and unanticipated slowing in domestic demand growth, leading to an involuntary build-up of stocks. If that were the case, output growth could be expected to fall during 2008 as firms sought to unwind this build-up. But there were several reasons for caution. First, the initial ONS expenditure data releases, particularly for business investment, were prone to substantial revisions. Second, most of the increase in stocks was reported to have been in the construction sector, not the retail or manufacturing industries, and so did not necessarily indicate a broad-based slowdown in the demand for goods and services. The Home Builders Federation (HBF) survey suggested that stocks of homes and work in progress relative to demand had been at their highest levels in the fourth quarter since the series began in 1992, which was consistent with the sectoral pattern of stockbuilding reported by the ONS. Third, market intelligence from retailers did not suggest that there had been such a sharp fall in retail spending growth in the fourth quarter as a whole. Fourth, survey evidence did not show a sharp fall in demand for consumer services.

More timely indicators of consumption had been mixed. Retail sales volumes had rebounded in January, growing by 0.8%, but the latest CBI Distributive Trades Survey implied a slowing in February. Interpretation of these data was complicated by uncertainty about both the seasonal adjustment of retail sales data at this time of the year and the slowing of the retail sales deflator relative to the analogous RPI series. The GfK headline measure of consumer confidence (seasonally adjusted by the Bank) fell in February to its lowest level since 1992, with a further drop in the proportion of respondents who thought that this was a good time to make a major purchase. The latter might reflect a tightening in credit conditions facing households. The low levels of the GfK headline and other consumer confidence measures might also reflect more general pessimism about economic prospects.

Investment intentions had so far been less affected by the turmoil in credit markets, although the rate of growth of lending to the private non-financial corporate sector had slowed. The commercial property sector remained under stress, with property prices continuing to fall significantly. There was little news about the non-financial sectors in the broad monetary aggregates; the annual growth rate of households’ money had remained steady at around 9% in January, although private non-financial firms’ money had slowed somewhat.

Output indicators for this quarter had shown some resilience, and did not seem consistent with a slowdown in response to earlier unanticipated demand weakness. Both the manufacturing and services CIPS/NTC activity measures picked up in February, and, together with January’s data, suggested that output growth in the first quarter might be a little above the level expected at the time of the February Inflation Report.

The housing market was evolving broadly in line with the assumptions underlying the February Inflation Report projections. The average of the lenders’ house price indices had fallen 0.4% in February and the preview of both the backward and forward-looking Royal Institution of Chartered Surveyors (RICS) survey price balances had suggested that they had fallen again in February. The preview of the RICS sales-stock ratio had suggested that this had dropped to its lowest level for over a decade. But the other RICS activity indicators were broadly unchanged and those provided by the HBF had strengthened slightly. Mortgage approvals for house purchase had also increased a little. The spread between two-year fixed rates on mortgages and swap rates (lagged one month) had increased further and was now around a percentage point higher than in August last year, while the annual growth rate of secured lending to households had fallen in January to its lowest level since 2001.