The scale of losses and the economic fallout from the credit crunch may not be as bad as feared and sub-prime write-offs could end up costing less than half market forecasts, the Bank of England said on Thursday.
The credit crunch has frozen money markets and rattled consumers around the world, pushing the global economy to the edge of a sharp slowdown after banks lost confidence in each other due to defaults on low-end mortgages in the United States.
If the fallout from the crisis turns out to be not as drastic as many fear, the implications for global interest rate -- and fiscal -- policy will be significant.
Current market estimates of sub-prime mortgages amount to nearly $400 billion and the IMF has said the wider cost to the financial sector could rise to $1 trillion.
"All of them are potentially significant overestimates of the losses within the wider economy associated with the financial market crisis," the BoE said in its twice-yearly Financial Stability Report, estimating actual losses could be closer to $170 billion.
"Using a mark-to-market approach to value illiquid securities could significantly exaggerate the scale of losses that financial institutions might ultimately occur. It will exaggerate to an even greater extent the potential damage to the real economy."
The BoE has been criticized for taking an unsympathetic line on the lending squeeze. The U.S. Federal Reserve has drastically cut interest rates and, along with the European Central Bank, made cash much easier for banks to get hold of.
However, the BoE responded to pressure to ease the squeeze last week, announcing an unprecedented 50 billion pound swap scheme under which banks can trade in their hard to shift assets for risk-free government debt, which is now going to plan.
The central bank is clearly concerned about the consequences of the credit crunch, but Deputy Governor John Gieve struck an optimistic tone in a statement released with the report.
"The unavoidable correction after the credit boom is proving protracted and difficult," Gieve said. "While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months."
BoE policymakers say they are wary of rescuing institutions from the consequences of their own risky behavior and have to balance the very real threat of rising inflation against the harder to gauge prospect of a decelerating economy.
"Losses recorded by financial institutions erode their capital, which may reduce their ability to offer finance to other households and corporations. This may have a detrimental impact on economic performance," the BoE said. "But it is at least partly offset by the household sector being in a less weak state than if its mortgage debts had had to be repaid in full."
Nonetheless, there is strong evidence to suggest the British economy is already suffering at the hands of the credit crunch, with house prices falling, home loan approvals at record lows and consumer confidence at 15 year lows.
BoE arch dove policymaker David Blanchflower warned on Tuesday policymakers must act aggressively to stave off the real risk of following the United States into a recession and a 30 percent slump in house prices.
Other members of the MPC have been more sanguine about the economy. Governor Mervyn King told lawmakers on Tuesday that a period of slower growth would not be a "disaster", saying it wasn't all doom and gloom just yet.