Wednesday, 26 August 2015

Market corrections

If we remember that the world financial collapse happened in 2008 with the fall of Lehman Brothers rather than China's catastrophic 2015, we can see that the world is in the middle of a market correction.

The worry is that a slowdown in China could slow the world economy, and have a much bigger negative effect than anticipated on the world's markets. Of course, we are not in a bear market yet [a bear market is defined as a 20% drop in stock prices].

A recent survey of household finances by the Bank of England suggested that if base rates rose from 0.5 per cent to 2.5 per cent, the proportion of mortgage borrowers judged to be vulnerable [defined as spending more than 40 per cent of their monthly gross income on debt repayments] would double from 4 per cent to about 8 per cent. However, if household incomes also rose 10 per cent, the proportion of vulnerable borrowers would only increase to 6 per cent.

The notion that the Bank has been deliberately keeping rates low in order to subsidise borrowers at the expense of savers has gained some traction, yet it is based on a misunderstanding of the objective of monetary policy. The Bank’s mandate is to keep inflation close to its 2 per cent target over the medium term. This facilitates overall GDP growth in the economy, so getting this balance right is to the ultimate benefit of both savers and borrowers. Their long-term interests are aligned.

Now if the world markets keep dipping the BoE would naturally lower interest rates or devalue the pound  as instruments to correct the situation, but how do you lower 0.5% and how does that affect the required rate rise of the future?

Perhaps we have arrived at the time where the markets should be left alone?

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