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The Bank of England has said that the health of the UK economy has "deteriorated materially” as it warns it will be harder for families and firms repay or refinance debt.
Banks were told to ramp up capital buffers to ensure they can weather the storm.
"The economic outlook for the UK and globally has deteriorated materially," the Bank said as it published its latest Financial Stability Report, largely blaming the impact of the war in Ukraine.
The Bank said the outlook for the UK economy is "very uncertain".
Watch: How does inflation affect interest rates?
“Although downside risks will present headwinds, the report said that UK banks have capacity to weather the impact of severe economic outcomes,” it said.
But it would lead to less money flowing to borrowers, officials said in Tuesday’s report.
“In such scenarios, banks are likely to manage prudently their lending activity, commensurate with changes in credit quality and the real economy.”
Some households are also likely to struggle with repaying their debt. Around 80% of mortgages are currently on fixed interest rates – compared with just 30% nine years ago.
But some 40% of these are set for renewal this year or next, pushing interest rates up for these households.
Household finances are under pressure from higher interest rates and the rise in prices. We expect household finances to become more stretched in the year ahead. https://t.co/HrpZV9ufUm #FinancialStabilityReport pic.twitter.com/i7cvGHSogT
— Bank of England (@bankofengland) July 5, 2022
Households have come under increasing pressure in recent months, as the UK's annual inflation rate hit 9.1% in May.
"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 BoE said.
Households with the lowest income, which spend the largest proportion on tax and essential items, would find it hardest to adjust spending in response to rising prices.
Businesses with higher exposure to energy and fuel prices such as manufacturing and transport could face higher costs, even as falling household real incomes damp demand for discretionary spending. In the medium term, the BoE predicts that this slowing demand will lead to a rise in unemployment.