Household debt The Bank’s conundrum countdown – Tightening policy in the shadow of a debt overhang 17 June 2014 by Matthew Whittaker Matthew Whittaker If Mary Poppins taught us anything, it’s that a British bank is run with precision. But against a backdrop of rapidly changing and sometimes conflicting economic data, the balancing act currently facing the Bank of England requires a level of calibration rarely before seen. Clearly monetary policy must be tightened over the coming months and years. Move too slowly and it may fail to head off what some view as a potentially over-heating economy fuelled by our extraordinary monetary conditions. Move too quickly, ahead of solid growth in household incomes, and it risks pushing significant numbers of already highly stretched borrowers over the edge. This is the policy conundrum of our times. Today’s inflation figures show a drop to 1.5 per cent, average wages continue to fall in real terms and the Monetary Policy Committee (MPC) thinks that slack in the labour market amounts to 1-1½ per cent of GDP. Yet the clamour for an increase in the Bank of England’s base rate is growing. Tomorrow’s publication of the latest MPC minutes will highlight the extent to which members of the committee believe the decision is becoming “more balanced”, and even the previously dovish Mark Carney has declared that rates might rise “sooner than markets currently expect”. So where is the inflationary pressure coming from? GDP growth has been strong over the past 12 months and employment continues to surpass expectations. If these trends persist then the spare capacity identified by the MPC might erode quickly in the absence of any improvement in productivity. In any event, we mustn’t forget that 0.5 per cent is an emergency level: rates must rise if the economy is to normalise, and ‘baby steps’ and gradual adjustment are likely to be preferable to a sudden jump. And of course in one area, the economy’s positively booming again: housing. Nationally, ONS data suggests that prices are rising at around 10 per cent a year, with values in London up 18.7 per cent. There are some suggestions that thepace of this expansion is slowing, but house price inflation remains a long way out of step with the broader pace of economic growth. Rate rises can play a role in cooling this market, but it’s the Bank’s Financial Policy Committee that has the clearest responsibility in this area. It is meeting today, though we won’t find out what it has decided until next week. It will not yet be able to make use of the new powers endowed on it by George Osborne to impose maximum loan-to-income ratios on banks’ mortgage products – the Chancellor has committed to legislating by the end of the Parliament – but it does already have powers of ‘direction’ in this regard. If it chooses to exercise them, it is hard to imagine any such directions being ignored by lenders. The division of these monetary and macro-prudential responsibilities post-crisis allows for much more nuanced policy making and should be welcomed. The idea is that the two sides of the Bank will work closely together to gradually unwind today’s emergency position while responding quickly to prick potential price bubbles in specific markets such as housing. But in taking these already very difficult judgements, the two committees are hampered by the presence of a significant debt overhang among existing borrowers. This is the obvious conundrum that all too often remains ignored: rate rises and macro-prudential interventions might be required to avoid repeating the mistakes of the recent past, but they spell trouble for many existing borrowers who remain close to the edge despite five years of rock bottom interest rates. For some borrowers, the problem is one of affordability. Even in today’s low rate environment, one-in-five mortgagors report having difficulty meeting their monthly repayments, up from one-in-ten a decade ago. And our modelling suggests that a quarter (27 per cent, or 2.3 million) would be spending more than a third of their net income on repayments by 2018 if the base rate were to rise in line with current market expectations – even where we make the assumption that lenders absorb some of the increase without passing it onto borrowers. For other borrowers, the problem posed by changes in Bank policy comes down to choice. The tightening of lending criteria – by banks themselves as well as in reaction to new regulatory conditions – since the financial crisis has created a new cohort of potential ‘mortgage prisoners’. Having entered the mortgage market when access to credit was easier – with high loan-to-value and interest only mortgages forming part of the mainstream for example – these borrowers are now finding that they cannot access suitable products for re-financing, leaving them ‘trapped’ on their existing provider’s standard variable rate (SVR) and therefore fully exposed to future rate hikes. Around one-in-ten are likely to find their choices restricted by a lack of equity – with the problem looking significantly worse in those parts of the country such as Northern Ireland where house prices have fallen most sharply – and many more face potential difficulty associated with their personal circumstances. Our estimate is that the introduction of amaximum loan-to-income ratio of 3.5, as proposed by the Business Secretary, would affect around 2.7 million existing borrowers. Even with a ratio of 4.5, the number who might struggle to re-mortgage would be over 1.5 million. Where these two problems collide – among borrowers who can’t insulate themselves against an increase in borrowing costs even though they can see the affordability problem coming – the fall-out is likely to be particularly severe. Our modelling suggests that some 800,000 households are already in this position, even before any additional tightening of lending rules. Clearly the Bank shouldn’t jeopardise future stability in the name of protecting vulnerable members of the stock, but flexibility is required. If not, the aims of the Bank (and of the government) risk being undermined by a new wave of arrears and defaults and by a debt overhang that weighs on consumer spending and therefore growth. With this in mind, ‘transitional arrangements’ in the MMR allow for the waiving of the new affordability tests for existing customers who are not looking to borrow more money. A similar exemption might be considered in relation to any future loan-to-income cap. But anecdotal evidence suggests that lenders are not using the transitional arrangements, even where it would help to ensure the continued viability of their customer by reducing their monthly repayment. Dealing with the inherent tension between fixing the flow and protecting the stock is likely to require some creative thinking. There is no painless answer, and it is inevitable that part of the solution will involve some existing borrowers leaving home ownership altogether. But it is important that the trade-offs and challenges are clearly recognised and articulated. Getting the balance right will call for an approach to policy that is practically perfect in every way.