Bank must not rule out another credit binge

If the post-covid party gets too exuberant, Threadneedle Street has to be ready to take away the punch bowl before it’s too late

After more than a decade of economic disappointment and heightened risk aversion in the wake of the financial crisis, it is easy to dismiss warning signs that exuberance is once again creeping into the UK economy.

Now that the economic straitjacket of lockdowns has been lifted, households are eager to spend as they return to the shops in droves. With any luck, economic activity will be back to its pre-covid level by the turn of the year.

So far, everything looks rosy. But if history is any guide, it is often when the economy looks sound that excesses start to appear.

A little extra borrowing as part and parcel of a strong recovery is no cause for concern. However, what starts out as a sensible amount of risk-taking by households can turn into exuberance over time.

Although it is still very early days, three factors suggest that conditions are ripe for a consumer credit binge.

First, consumer fundamentals are favourable. Households have accumulated over £200bn in excess savings since the pandemic hit.

Part of this extra cash will be spent during the recovery phase of the upswing. The rest will further add to household net worth, which hit a record high of £11.4trillion in 2020 after rising 8.4pc on an annual basis – partly underpinned by surging house prices.

While the extra savings may act as a headwind to credit demand, increasing net worth is likely to underpin higher borrowing over the long term.

This is reminiscent of the early 2000s, when rising house prices encouraged homeowners to withdraw home equity to support consumer spending on big ticket items and home renovations.

Second, the UK banking sector is well positioned to lend aggressively. In its Financial Stability Report this month, the Bank of England reported that banks and building societies held over three times more capital than they had done before the financial crisis.

With enormous excess liquidity sloshing around the global financial system, banks can profit from expanding consumer credit while financing themselves at ultra-cheap short-term rates.

The latest Bank credit conditions survey for the second quarter shows a record rise in the expected availability of unsecured credit, such as credit cards and consumer loans.

Third, and perhaps most importantly, central banks and governments are continuing with record amounts of stimulus.

On top of the massive support from the Treasury and the Bank, the UK’S mid-atlantic economy has a brisk tailwind from fiscally supercharged Biden’s America and the ultra-easy monetary policies of the Federal Reserve – not to mention that of the European Central Bank.

The synchronised policy underpins rapid demand growth, holds benchmark rates artificially low and supports risk-taking by convincing banks, businesses and households that policymakers will lean against any undue slowdown in economic momentum.

However, the question still remains “if ” rather than “when” the robust upswing will lead to credit excesses.

Strong household fundamentals and wellcapitalised banks are the basis for durable economic growth. These are strengths to be welcomed.

Policymakers, especially central banks, have a responsibility to stage a timely withdrawal of support to keep growth on a sustainable path. But judging by their recent commentary, they remain too sanguine about the potential risks of overheating.

Despite sounding a little less dovish of late, the Bank’s policymakers continue to expect the current period of rapid growth and surging inflation to give way to much slower growth and subdued inflation by next year.

The post-lehman era, characterised by weak growth and low inflation, remains policymakers’ template for the future.

This seems misguided. As even a casual observer of economic history can see, with each decade comes new trends and fresh challenges to overcome.

The evidence emerging during the recovery so far suggests that risks are tilted towards stronger growth and price pressures over the 2020s than during the 2010s.

But alongside the growing inflation risks, the potential for credit excesses to emerge provides another reason for the Bank to consider exiting from its overly stimulative policies.

In addition to stopping asset purchases next month, the Bank should signal that it is prepared to raise the bank rate from its current historical low of 0.1pc in early 2022, or even sooner, in case inflation and credit risks continue to mount.

The Bank also has the option of demanding that financial institutions hold even more capital. That would help to ration credit and prevent lenders from becoming overextended.

A consumer credit binge that underpins a couple of years of rapid economic growth may feel good while it lasts. But once the illusion gives way to reality and the hangover kicks in, policymakers will wish they had acted sooner.

‘It is often when the economy looks sound that excesses start to appear’