Tomorrow the Bank of England is expected to raise interest rates for the first time in a decade, kicking off the first tightening cycle for monetary policy in 14 years. Whether or not the Bank’s Monetary Policy Committee behaves as markets anticipate, the expectation has triggered two big questions.
First there is the macro question of whether the Bank of England is right to raise rates now, and second the micro question of how big a deal a rate rise will prove to be for Britain’s families. Reasonable people can, and are, disagreeing on the former question – but more attention would usefully be paid to the latter.
In fact, your answer to the second question should be a prior to your macro answer about the right pace of rate rises. After all the goal of monetary policy isn’t the level of interest rates but the level of inflation, with the relationship between the two dependent on how rate changes affect households and firms.
The need to look again at that relationship (the “transmission mechanism of monetary policy”) is all the more pressing when it is a full decade since we saw such a rise take place. The country itself has changed in important ways since then.
Here’s one example. A key element of the transmission mechanism of a rate rise is via changes in mortgage costs. This dominates much of the public discussion about the effect of rate changes on households.
But how big an effect is it likely to have in practice? The Daily Mirror last week went with the understated headline: “Millions to get poorer next Thursday – and one in 20 could be made homeless”. Reading that you’d be forgiven for thinking a rate rise tomorrow would be an immediate catastrophe for British families and their housing costs.
But there are reasons why these disaster movie headlines of the immediate effects may be overdoing it, even leaving aside the obvious point that any rate rise this week is likely to be tiny.
Fundamentally this is because Britain has changed significantly over the last ten years in ways that mean far fewer households are exposed to the immediate feed through of a rate rise to their housing costs. You can think of this in three stages.
First, less of us own our own home. The share of families who own their home has fallen significantly since its early 2000s peak of 58 per cent to around 50 per cent today.
Second, this smaller share of British families that are owner occupiers are less likely to have a mortgage today because the proportion owning their home outright continues to break records. At the turn of the millennium, 35 per cent of families had a mortgage, while 23 per cent owned outright. Today that relationship is reversed, with the proportion of mortgagers falling to 24 per cent and being overtaken by the 27 per cent who own outright.
Third, even within the much smaller pool of mortgagors, there is another big change underway – the move away from variable and towards fixed rate mortgages. In the immediate aftermath of the financial crisis, over 70 per cent of mortgage debt was variable rate. Today the figure is just above 40 per cent (see chart below). A similar trend can be seen on wider personal debt that has rightly been the focus of much press and regulatory attention recently, with a move away from floating rate products, albeit from a much lower base.
The combination of these three trends – falling home ownership, growing outright ownership, and the shift towards fixed rate mortgages – means that only around 11 per cent of families have variable rate mortgages in Britain today. And they have smaller mortgage balances than those that have fixed – an average of £70,000 compared to £96,000.
To estimate the overnight mortgage impact of a rate rise, we can look at what happens if we add 0.25 percentage points to the interest rates paid by the 11 per cent of families with non-fixed rate mortgages. The result is an average increase in repayments of families of £6.40 a month (or 1.3 per cent of their existing repayments). Spreading the cost across all mortgage holders, the average repayment increase is just £2.50 a month.
Over time of course, increased rates would feed through to those favouring fixed rates mortgages – as new buyers enter the market and existing owners remortgage. Bank of England data helpfully allows us to see how fast that feed through is likely to be – at least on the remortgaging side. As the chart below shows, the vast majority of fixed rate mortgages expire in a year or more and it would take at least three years for any rate rise to feed through fully.
So the direct effect of a small rate rise on mortgage costs is relatively small in aggregate – especially at first. That will obviously not be the case for all families. A family with a big mortgage of £258,000 (in the top 10 per cent of mortgages) would see a £30 a month cost increase from a 0.25 per cent rate rise. And clearly the growth in those owning multiple properties, including via buy to let mortgages, means some will be very exposed indeed even to small rate rises.
What matters more is the future path of interest rates, which markets still expect to only reach a little over 1 per cent in 2021. For simplicity, assuming a straight 1 per cent increase in mortgage rates across all mortgages implies an average increase in costs of £31.50 a month for the one in four families who have a mortgage. That is obviously a lot of money but, to put it in context, more people (27 per cent of households) on much lower incomes will lose an average of £48 a month from the benefit freeze by 2020. Full pass through to all mortgages is also a very big assumption. You would hope lenders that significantly increased the spread of their lending rates over base rate when the Bank cut rates during the crisis, would slowly shrink those spreads.
It is also worth noting that all of the trends covered above have big distributional angles to them – right across dimensions of income, age and geography – that are important to fully understanding how monetary policy feeds into the real world.
For example, the drops in mortgaged home ownership are bigger among higher income families – not surprisingly given they started with higher ownership rates – who are likely to have lower marginal propensities to consume out of disposable income, further complicating shifts in the strength of the monetary transmission mechanism via mortgage payments (see chart below).
This is not an attempt to look comprehensively at the impact of a rate rise on household budgets –that would need to take into account increased savings income on the other side of the ledger from higher credit costs. Nor does it mean now is the right time to raise rates rather than later (on balance the case for waiting is strong). But it does provide some context to the scariest newspaper headlines.
It should also encourage all those involved in monetary policy to revisit assumptions about how interest rate changes feed into the real economy. It is likely that the transmission mechanism via quick changes in mortgage costs is likely to be both weaker and slower than it once was.
The rate rise debate should also encourage us to ask wider questions, not just about the monetary tools we have available to us, but also about the strength, timing and channel of how they affect the real economy. As we have been regularly reminded in the decade since the financial crisis – we know less than we thought we did.