Monetary policy On borrowed time? The need to make the most of the ‘window of opportunity’ provided by low interest rates 4 August 2015 by Matthew Whittaker Matthew Whittaker More than six years after the Bank of England’s base rate was cut to 0.5 per cent, interest rate rises finally appear to be back on the agenda. There may be good reasons for thinking that modest and gradual action will soon become appropriate, but the debt overhang associated with the pre-crisis credit boom continues to cast a shadow over the MPC. The task of setting monetary policy that best fits today’s macroeconomic needs while continuing to be alive to the difficulties this might produce for a sizeable minority of households remains a very difficult one. With inflation on the floor, talk of rate rises may seem premature. But with the economic recovery showing real momentum, unemployment approaching the estimated NAIRU and wage growth having returned, it seems more likely that CPI will climb steadily back towards its 2 per cent target once the effects of the one-off fall in global oil prices drop out of the annual comparison. As a result, Mark Carney and others at the Bank of England have talked up the prospect of taking the first steps on rate rises towards the end of the year – though they have also been very careful to point out that the date of the first move matters less than the overall trajectory of rate ‘normalisation’. It’s of course right that rates should rise at some point. Ultra-low interest rates heighten the prospect of misallocation of capital as investors chase returns, and they can contribute to bubbles. New macro-prudential tools – such as the ability to establish maximum loan-to-income ratios on banks’ mortgage products – provide the central bank with alternative ways of dealing with such risks. But these powers are complements to, rather than replacements for, rate movements. And there’s the broader point that moving rates away from the zero lower bound provides room to deal with the fallout of the next recession, whenever it arrives. As Gavin pointed out last week, sensible macroeconomics requires considering monetary policy not in isolation, but in tandem with fiscal thinking. So the moment at which rates should rise may not yet have arrived, but it appears to be approaching. Yet the Bank’s policy approach is made significantly more difficult by the continued presence of a sizeable number of households in which the legacy of debts built up before the financial crisis and credit crunch hit weighs heavily. Crucially, what matters is not just the stock of outstanding debt, but its distribution across households. The sharp fall in mortgage costs in recent years has provided very welcome relief for millions of homeowners. But the wider squeeze on earnings and incomes means that for many it has provided little more than some breathing space – easing the immediate financial pressure but not allowing them the opportunity to pay down their debts in any meaningful way. Seven years on from the start of the financial crisis, it seems likely that debt exposure among those on low and middle incomes remains little changed. Our estimate for 2014 suggested that around 1.1 million households were already ‘highly geared’ – spending more than one-third of their after-tax income on mortgage repayments, even with rates at historic lows. Based on an assumption that the base rate rose slowly towards 3 per cent by 2018, our modelling suggested this number might roughly double (to 2.3 million, or around one-quarter of all mortgagor households) – even after accounting for rising incomes and some narrowing of the spreads between the Bank’s rate and high street mortgage rates. Since undertaking that work, market expectations for the future path of the base rate have softened. As the chart below shows, at the time of the Bank’s May Inflation Report the base rate was expected to reach just 1.4 per cent by 2018. Given the recent relative strength of various economic indicators, it’s likely that this Thursday’s Inflation Report will show a slightly faster pace of increase. But interest rates are expected to remain well below their pre-crisis trend level of 4.5 per cent in the medium term, with Mark Carney suggesting that the new ‘normal’ might only be half as high. This implies that the impact of rate rises might not be as severe as we suggested 12 months ago. However, what remains critical is the sequencing of rising borrowing costs and rising incomes. Part of the reason why base rate rise expectations have been serially pushed outwards over the past six years is that economic growth, and more particularly household income recovery, has disappointed. It remains the case that even modest movements in mortgage rates could create affordability issues for a sizeable minority unless incomes across the distribution recover in a strong and sustainable way. And the problem of choice is likely to remain a live one for significant numbers. The tightening of lending criteria has created a new cohort of potential ‘mortgage prisoners’. Such borrowers entered the market when access to credit was easier but now find that they cannot access suitable products for re-financing, leaving them ‘trapped’ on their existing provider’s standard variable rate (SVR). With SVRs remaining low by historic standards this hasn’t created too many issues to date, but it leaves potential ‘prisoners’ fully exposed to future rate hikes. Putting a number on this group is extremely difficult. In 2014, our best guess was that up to two-fifths of mortgagors might be affected – through some combination of having very little equity in their home, holding mortgage types that are no longer available or having non-standard characteristics, such as being self-employed. More recent industry estimates suggest this figure remains in the right ball park. Of course, ‘prisoner’ status on its own may not carry much of a penalty. Some who fall into this category will have little left to pay off on their mortgage; others will have sufficiently high incomes to deal with SVRs that remain someway below historic averages. Where these two problems collide however – 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 could be particularly severe. The magnitude of the debt overhang is inevitably uncertain – we’ll update our modelling in the coming weeks – though it’s likely to be a problem that affects a minority in an acute way rather than something that has significant macro implications. We can’t and shouldn’t maintain rates at 0.5 per cent indefinitely, and taking baby steps towards some form of rate ‘normalisation’ could provide an important signal to borrowers used to ultra-cheap credit of the need to prepare for rising costs. In any event, what’s clear is that many of the recommendations we made last year for making the most of the ‘window of opportunity’ provided by low rates – including banks making pre-arrears contact with their customers, the FCA standing ready to take a stronger regulatory line with lenders where significant numbers of mortgage prisoners are trapped, and the introduction of new approaches to easing the transition out of the housing market for those with unsustainable debts – remain as relevant today as they did 12 months ago.