The economic outlook for the UK and the rest of the world has “deteriorated materially”, the Bank of England has warned.
Energy and fuel costs are rising rapidly around the world, pushing up prices in general more quickly.
However, UK banks are in a position to weather even a severe economic downturn, the Bank said.
It told banks to keep more money in rainy day funds to ensure they can weather any storm.
The Bank’s comments came in its latest Financial Stability Report.
International forecasters such as the IMF and OECD have said Britain is more susceptible to recession and persistently high inflation than other Western countries, all of which are grappling with energy and commodity market shocks.
While the Bank said the UK’s banking sector was well-placed to cope with a severe downturn, it said banks must increase the amount of money they set aside to absorb shocks. Starting a year from now, banks will be required to set aside a sum equal to 2% of their assets as a buffer, as opposed to the normal 1%.
The Financial Policy Committee said it could vary the rate in either direction depending on how the global economy pans out.
Households have come under increasing pressure in recent months, as energy, food and fuel prices soar.
In April, domestic energy bills jumped after the price cap was increased by 54% to £1,971 for the average household.
Experts believe this could rise again in October, to around £2,800, which could help to push inflation up to more than 11% later this year.
“Commodity price volatility following the Russian invasion of Ukraine has further exacerbated price pressures facing households and businesses, and has had implications for the financial system,” the Bank said.
Some households could struggle with debt. About 80% of mortgages are currently on fixed interest rates, but some 40% of these are set for renewal this year or next, which could push up costs for these households.
“Tighter financial conditions and reduced real incomes will weigh on debt affordability for households, businesses and governments in many countries, increasing the risks from global debt vulnerabilities,” the Bank said.
However, despite increasing pressure on household budgets, the Bank said financial institutions were resilient to debt vulnerabilities among households and businesses.
The pound also lowered 1.6% against the dollar and hit a two-year low on Tuesday.
Another surge in gas prices in Europe and the UK which could push inflation higher again, has added to fears the economy could slide into a recession.
It says something about the lengths that have been gone to over the past 15 years to shore up the resilience of the banking system that it looks, according to this report, comfortably able to withstand not only the biggest economic contraction in 300 years over the pandemic, but also stagflation and the highest inflation in four decades.
It’s more households and small firms, rather than the financial sector, that are vulnerable at the moment.
The Financial Policy Committee said that households’ debts haven’t shot up – yet – in response to the cost of living crisis, and it also takes the view that the proportion of households who spend a large portion of their incomes on servicing debts will remain manageable, in spite of rising interest rates, because of the package of help from the government.
Its members are similarly sanguine about the effect on small businesses, acknowledging they could be hit by falling demand from households with declining real incomes, but forecasting that it would “take large increases in borrowing costs” to impair their ability to service their debts.
Let’s hope the committee’s optimism isn’t misplaced.
Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown, said the Bank’s verdict seems to be that “the situation isn’t as quite as bad as previous crises”.
“Consumers might be coping with the biggest hikes in prices in four decades but compared to the months before the 2008 financial crisis hit, households aren’t as likely to dig themselves deeper into more debt,” she said.
“The escalating cost-of-living crisis is so stark that the government has already moved to pledge more support to those on lower incomes facing sky-high energy bills.”
She added that the Bank “expects businesses on the whole to struggle on”.
While many firms were struggling with supply chain challenges and weakening consumer demand, “overall it’s going to take a much larger shock to see a domino collapse of companies unable to pay their debts”, Ms Streeter added.