Interest rates and the economy

Careful now

Why even small interest-rates rises could have a big impact on consumers

IN NOVEMBER 2003 the Bank of England's monetary-policy committee (MPC) raised interest rates by 0.25%, the first increase in almost four years. With hindsight, it seems a straightforward decision. The economy was growing steadily, unemployment was low, house prices were shooting up and banks were lending freely. Yet at the time there was great anxiety about the change. The fear was that the increased burden of consumer debt would make even a small rise in interest rates bear down heavily on spending.

That worry is all the greater now, as the bank contemplates a similar move. As The Economist went to press on April 7th the MPC was expected to keep its benchmark rate at 0.5%—but a quarter-point increase seems likely as soon as next month. Debt is worse, relative to incomes, than in 2003 (see chart). Other pressures on household finances are greater now than then. Wage growth is sluggish; inflation is far higher; job prospects are poorer. And taxes are going up. In the circumstances, an increase in interest rates could easily provoke a damaging cutback in spending by nervous consumers. One big, if subtle, reason for concern is the stark polarisation between the cash-rich and the debt-poor.

If each household had an equal share of the cash and debt held by all, there would be little to worry about. True, personal debt is around 1.5 times post-tax income, which means that a percentage point increase in interest rates, if fully passed on by lenders, would take up 1.5% of income in higher debt-service costs. On the other hand, the income effects of interest-rate changes do not work in only one direction. Households in aggregate also have large cash deposits, and higher interest rates raise the income that is earned on them. The stock of cash is a bit smaller than the stock of debt, so the overall effect of interest-rate increases would be to depress household income. But as long as deposit rates rise in tandem with borrowing costs, the cost of a percentage point rise in rates would be less than 0.3% of incomes.

That reckoning, however, understates the likely impact. Analysing the debt and cash holdings of all consumers lumped together reveals little about the effect of interest-rate increases on spending. That actually depends on how the aggregate cash hoard and debt burden is divided.

People typically do not have both large debts and piles of cash, since it would make sense to use the latter to pay off the former. Rather there is a financial spectrum with, at one end, debt-laden householders, usually young, who have recently taken on a hefty mortgage and have little spare cash; and at the other end, older savers who have paid off their mortgages, or who have traded down to smaller homes and banked the proceeds.

These different sorts of consumers will respond to interest-rate increases in ways that are unlikely to be neutral for the economy. The indebted will cut their spending to free up the extra cash to service their loans. Once rates start to rise, those with the biggest debts might be anxious to save harder to pay down those debts at a faster pace. At the other financial pole, the cash-rich and debt-free (by definition savers not spenders) might well spend little, if any, of the extra income they gain from higher deposit rates.

Any squeeze on debtors' incomes might be mitigated if banks chose not to pass on any increase in funding costs stemming from higher base rates. That scenario is optimistic. The gap or “spread” between the Bank of England's rate and the average interest rate on mortgages (which account for four-fifths of household debt) has narrowed a bit recently, though it is much higher than before the financial crisis. This narrowing owes little, it seems, to banks competing more vigorously for mortgage business. Rather it reflects lower rates for borrowers whose fixed-rate deals had expired and lapsed into cheaper variable-rate mortgages.

In one sense, this is helpful: it has lifted the incomes of some borrowers at the banks' expense. But it has also made the economy more sensitive to changes in short-term interest rates. Before the crisis, around half of mortgages were at variable interest rates; by the end of last year, the share had risen to 69%. This greater sensitivity is heightened by the fragile state of Britain's housing market. Higher rates will crimp the already-weak demand for homes and weigh on house prices—perhaps spurring anxious borrowers to spend less and pay off their mortgages quickly.

A borrower not a saver be

A big enough interest-rate shock would start a downward spiral in debtors' finances, spending and house prices. Rising defaults would exacerbate the damage. For this reason, the MPC is likely to tread carefully. The “glacial pace” at which interest rates are likely to rise—perhaps 0.25 percentage points every three months or so—is unlikely to be dangerous, reckons Kevin Daly of Goldman Sachs. If spending suffers unduly, “the MPC would be able to deal with it,” he says.

The polarisation of household finances that makes the impact of a rate rise so uncertain also helps to explain why some MPC members feel the need to act. Debtors are hoping that interest rates stay low, but savers and bondholders need to be reassured that today's high inflation won't be allowed to persist. A small rate increase would be a victory for savers. The needs of the economy mean that, overall, monetary policy will continue to favour debtors.