Royal Bank of Scotland chief executive Sir Fred Goodwin said yesterday that the next move in UK base rates was likely to be up rather than down, in spite of falling house prices and slowing economic growth, and declared people "shouldn't forget the danger that inflation represents".
His comments highlight the dramatic shift from a likelihood only a few weeks ago of further cuts to bolster the flagging economy, to a probable no-change scenario, and then in recent days to the prospect of rate rises from the Bank of England.
Goodwin believed the ongoing fall in UK house prices would turn out to be "somewhere between" a relatively painless "orderly" correction and a "disorderly" process with "a lot more pain", but said there was a "high probability" that it would be towards orderly.
The Royal chief executive defined orderly as "house prices coming down by 5% over the next 12 months or so". He declined to put a figure on what would represent a disorderly correction but said this would be where prices "start to fall dramatically...and without there being any obvious end in sight".
His comments about the scenario probably being closer to orderly imply he expects UK house prices to fall by more than 5% over the next year, but not by much more.
He made no bones about Royal having become more picky about the people to which it was willing to give a mortgage.
Referring to prospective mortgage customers, against the current backdrop of rising interest rates on home loans caused by an increase in risk premium and higher wholesale funding costs triggered by the global credit crunch, Goodwin said: "In doing mortgage business, if interest rates are going up, the person we are lending money to here..we need to factor in the fact that their mortgage costs might go up. We also need to factor in the fact that the value of the property might go down.
"Wherever you draw the line on who you would or wouldn't lend to, it has just moved."
Asked if this meant Royal was rejecting more mortgage applications than before, Goodwin replied: "Absolutely - which I think is better than having your application accepted and then finding out you can't afford the mortgage." The Bank of England's Monetary Policy Committee has cut UK base rates by a quarter-point three times this cycle, in December, February and April, and they now stand at 5%.
In late April, most economists had expected a further cut in either May or June, but these hopes were dashed by an unexpected leap in annual UK consumer prices index inflation to 3% in April. The MPC forecasts inflation will rise to nearly 4% later this year - almost double its 2% target.
A relentless flow of data signalling extremely strong upward pressures on UK inflation has moved financial markets in recent days to price in the possibility of a rise in UK base rates before long. Matters are not being helped by a surge in oil prices to nearly $140-a-barrel.
Goodwin, agreeing with this developing market view, said: "The likelihood is that rates will go up from here: I don't think by very much but I think up is the current thinking."
Referring to the inflation target, Goodwin added: "It is a feature (of the MPC brief) that has served us very well. We shouldn't forget the danger that inflation represents, so having the Bank of England focusing on inflation I think is an important (thing)."
When it was put to him that inflation was low by historical standards and that the surge in consumer price inflation had not yet fed through to wage settlements, Goodwin replied: "It wouldn't take long. When it does, it tends to come through pretty quickly."
Referring to the MPC, he said: "For all they are targeting 2%, the last I saw there was a forecast it could get up to 3.7% this year...We shouldn't forget that inflation is a danger to the economy, as well as falling property prices."
On the housing market correction, Goodwin said: "The real issue is how long it might go on for...An orderly correction, I think, is something which could be completed without too much pain. Clearly if it is a disorderly correction, we could look to see a lot more pain. I am hoping for the former. I suspect, in reality, it will fall somewhere between the two."
However, he emphasised: "I would think it would be very much towards the orderly end of the spectrum. I would attach a high probability to that. That is my sense of it."
Goodwin is confident the UK will avoid recession.
Asked by The Herald if he would estimate the probability of recession, as opposed to a significant slowdown in economic growth, Goodwin replied: "I do think in the UK what we are seeing is certainly a slowdown. I do think it will stop short of a recession. I think recession is a word that gets kind of bandied around a lot but I think there have only been three since the war and this doesn't feel like one.
"We have got very high levels of employment, a lot going on in the economy. People are still spending money. They are spending it more slowly than they were a year ago. I think we will be much closer to the orderly end of the spectrum than the disorderly."
Goodwin's comments on the economy came as Royal issued a trading update which the chief executive said "could probably be summarised very succinctly as no new news - very much a continuation of the trends which we identified in our earlier interim management statement back in April".
Royal unveiled £5.9bn of additional writedowns stemming from the global credit crisis, which kicked off in earnest last summer following massive default on home loans by US households with poorer credit ratings, in this previous April statement.
In spite of Goodwin's impression of Royal's statement, shares in the bank yesterday plunged 21p or 9% to 212.25p in a very weak sector. Royal shares went up immediately after Royal's statement yesterday morning, then were pegged back to roughly level, before plunging later in the day.
Goodwin's comment that Royal's "risk appetite is tempered by a cautious stance in relation to short-term economic factors and market conditions" was being cited as one reason for the fall.
Elaborating, Goodwin said: "We are cautious in unsecured credit. You would be cautious on any property lending at this time because it is clear that UK property prices certainly residential property prices, have started to decline."
However, highlighting his expectation that Royal would "carry on growing into the future", he added: "We don't forecast any of this takes us to the end of the world as we know it but clearly there are some short-term pressures in some of the markets in which we operate and very clearly in the UK."
Royal said the performance of "many" of its businesses since the start of 2008 "remains good, though results have been held back by the effects of the continuing deterioration in credit markets".
It added: "Writedowns on credit market exposures are expected to remain within the estimates indicated. Overall, the group's underlying results, excluding writedowns on credit market exposures, are expected to remain satisfactory."
Royal said cost savings and income benefits from its integration of the parts of ABN Amro which it bought last year for about £10bn were "slightly ahead of target".
Goodwin was confident Royal would achieve an acceptable price for its insurance business, which includes Direct Line and Churchill, but emphasised there would be no quick announcement on a sale.
This RBS Insurance division is the main plank of businesses earmarked by Royal for disposal as part of a plan to realise more than £4bn of gains on asset sales and help boost its key Tier One capital ratio above 6% by the year end.
Goodwin said: "In relation to RBS Insurance, we are in discussions with a number of potential purchasers. Those discussions are ongoing. Obviously, for a disposal of this size, the discussions will take some time and our determination is to achieve the appropriate value. So we are not doing this against the clock, we are doing this to achieve the appropriate value and it will be some time before we have any announcements to make in relation to RBS Insurance."
He added: "It is not a thing that gets done quickly. I guess I am just trying to temper expectations a little bit. I wouldn't be holding my breath to hear any more about this."
Goodwin's comments signal months more uncertainty for the RBS Insurance employees, including about 1800 who work in Scotland.
Asked about Royal's recently completed rights issue of shares to raise £12bn, Goodwin said: "It is a great relief for all of us to have got the thing successfully concluded I am glad to have it done. The money should be in the bank tomorrow sort of thing, so feels a good place to be, so I think we are glad to have it done."
Asked if Royal might have to start another rights issue if it did not conclude a sale of RBS Insurance, Goodwin replied: "No we will not be doing another rights issue if we don't sell insurance, and we remain confident that we will sell insurance."
Goodwin said Royal had, on top of job losses arising from integration of the ABN Amro businesses which have not been specified by Royal but have been estimated at around 6000, the bank had cut about a further 1000 posts as a result of the credit crunch. Most of these were in London and the US. Royal employs about 170,000 people.
There has been much speculation about Goodwin's position at Royal.
Asked about this, he replied: "As ever, I am someone that never tries to look very far into the future. Right now, I am looking forward to taking the business forward."
Asked about the level to which banking stocks had sunk, Goodwin said: "I think we would generally be of the view that bank stocks in general have been oversold by a considerable margin. I think we are overdue to see them starting going back up."
However, he added: "I am conscious, though, that that is influenced a lot by news flow There is more bad news coming out of the industry and the economy than there is good news and that is not a great backdrop for share-price appreciation."
Royal confirmed yesterday that it had fulfilled its commitment to use the Bank of England's liquidity facility, which the central bank estimates will extend more than £50bn to the industry as a whole.
