How badly would UK mortgage borrowers be affected by a rise in interest-rates?

A major feature of the credit crunch era has been the reduction of many official interest-rates to what often euphemistically called the lower bound. In the past this was usually assumed to be zero –  for example I worked in futures markets for short-term interest-rates where the maximum price of 100 meant 0% was the minimum and hence we have the acronym ZIRP for Zero Interest Rate Policy. Of course regular readers of this blog will have been aware for some years that I expected the ZIRP barrier to fall and the expected candidate the European Central Bank has an official rate of -0.2% as I type this.

The Bank of England has,like in so many areas, had a confused view of events as illustrated by its Governor Mark Carney regularly telling us that the lower bound for Base Rates in the UK is 0.5%. Has he never looked across the Channel to the Euro area. He also regularly yo-yo’s between telling us a Base Rate rise is near and one is far away. It is in the light of these matters that I note the latest Bank of England Quarterly Bulletin has an article entitled as shown below.

The potential impact of higher interest rates on the household sector

Is that a euphemism for higher mortgage rates? Let us investigate further.

What is the state of play as regards debt?

The situation according to the Bank of England survey is shown below.

The latest NMG survey suggests that the size of the average outstanding mortgage was broadly unchanged over the year to September and stands at around £83,000. For those with unsecured debt, the average amount of debt outstanding was reported to have increased a little over the past year, to around £8,000.

Just to be clear the average mortgage debt is for those who have a mortgage and the unsecured debt average only applies to those who have unsecured debt.

In terms of the ability to support such debts then the income situation is as follows.

Households also reported modest increases in income relative to the 2013 survey: in the latest survey average annual income before tax was around £33,000, although it was somewhat higher for mortgagors at around £43,000.

The impact of higher interest-rates

Typically the Bank of England is concerned first about the impact of higher interest-rates on financial stability otherwise known as the banking sector. However it then looked at the impact on households. The actual changes are described below.

The analysis in this section is based on a scenario in which
Bank Rate rises immediately by 2 percentage points. This
increase in rates is assumed to be passed through to
households in full, and unless otherwise stated, household
income is assumed to remain unchanged.

In these times a 2% increase in interest-rates seems quite a lot does it not? I would imagine it was chosen because Governor Carney has suggested Base Rates might eventually rise to 2.5% in the UK. That is of course on the even days of the month when rate rises are on their way as opposed to the odd days of the month when they are not.

Anyway we find that an old friend really matters as to what impact we see and it is something that if a big issue in the credit crunch era.

An estimated 37% of mortgagors would need to take some
kind of action if interest rates rose by 2 percentage points
while income remained unchanged , equivalent to 12% of all households. This is somewhat lower than a year ago . But if the income of all households were to rise by 10%, the proportion of mortgagors that would need to respond falls
to only 4% , equivalent to 1.3% of all households.

If you read elsewhere that the Bank of England is sanguine about the economic effect of higher interest-rates this is because they are using numbers where the wages fairy has been busy. As we stand right now the wages fairy has been rather absent over the credit crunch period and only on Friday I discussed the International Labour Organisation’s views on this issue.

What about savers and borrowers?

Sadly the Bank of England has copy and pasted old orthodox theory on the impact of changes in interest-rates on borrowers and savers.

The survey responses suggest that, when interest rates rise,
the average MPC of borrowers out of higher interest payments is expected to be around 0.5……..The
average estimated MPC of savers out of higher interest
receipts was much smaller, however, at 0.1, implying that they would spend only £1 more for every £10 of extra savings income.

I would like to see more research in this area as the cuts in savings rates have been savage and there must be many people who relied on savings income who have been hit hard. Therefore I would expect them to pretty much spend any extra income.

The Bank of England uses this research to conclude that a rise in interest-rates would have only a small effect on the UK economy.

Overall, these results do not imply that increases in interest rates from their current historically low level would have unusually large effects on household spending……And a 2 percentage point rise in interest rates could reduce spending by around 1% through this channel (a redistribution of income from borrowers to savers (the
cash-flow effect).

In these times of economic difficulty a 1% reduction in household spending would lead to even more deflation paranoia in my opinion.

The generation game

We do get some thoughts from the Bank of England on the distributional impact of an increase in interest-rates on different age ranges. The group most adversely affected is shown below.

On average, the reduction in income and spending is likely to be larger for households aged between 25 and 44, since they are more likely to be borrowers.

And the relative winners?

But higher rates would increase the income of older households, on average, since they are more likely to be savers,

Actually if we wish to put it relatively simply the threshold us age 55.Those younger lose and those older gain. Oddly the Bank of England seems to think that those who gain in the 55-64 age group will not spend an extra penny! However one analyses it the starting gun is potentially fired on something of a generational war.

On average, younger households, who are more likely to be
borrowers, will be worse off, while older households, who are more likely to be savers, will gain.

Comment

There is much to consider from this research by the Bank of England. However the days when central banks were relatively independent arbiters of events are long gone.We can no longer consider them to be what used to be called disinterested like say John Jarndyce of the novel Bleak House. Therefore any research needs to viewed through a reader which allows for their own spin on events. So what do we see?

Firstly the Bank of England has launched an ongoing campaign against savers. It cut Base Rates to 5% and reduced longer-term interest-rates via its purchases of UK government bonds. Back in September 2010 Deputy Governor Charlie Bean told us this in a Channel 4 interview.

Indeed when asked this question.

This bad news for savers is the point of what you are doing?

He replied “yes”.

 

After that the Bank of England added to savers pain in the summer of 2012 with the Funding for (Mortgage) Lending Scheme which drove savers and depositors interest-rates even lower.

Secondly this sort of partial analysis of generational issues ignores the fact that younger people are the victims of something that very low Base Rates have contributed to. That is the rise of house prices without any similar rise in wages. If we look at the fall in UK real wages of approximately 10% and then the rise in house prices then we might even argue that they have been “crowded out” to use a phrase rarely heard these days. If we add in the rise and rise of student debt burdens -only perhaps affordable at such low interest-rates then the gain for them seems more like a ball and chain.

Thirdly this sort of analysis that a 2% rise in interest-rates has double the impact of a 1% rise is at best laughable. If we go back to when Base Rates were 5% and applied such analysis then the cuts to 0.5% would have “saved” us. But they did not! My contention is that two factors were at play. Firstly the rapid and savage cuts disturbed people and changed their behaviour which offset some of the expected gains. Secondly that as we approach zero interest-rates (from around 2%) a bit like in quantum theory physics reality changes. The gains from interest-rate cuts become very limited and run the danger of becoming losses.

Finally I suspect that this research was commissioned back in the days of the Mansion House speech when Governor Mark Carney hinted heavily at Base Rate rises. Accordingly it would appear that the official view of their impact needed “adjustment”. Now such work is published the “dedicated follower of fashion” has moved on to pastures new.