06 July 2023
The fact that the Bank of England (BoE) was forced to raise interest rates by another 50 basis points has prompted questions around whether interest rates are still an effective way to reduce inflation. The answer, as always in economics, is a clear and simple – yes, no…maybe.
Higher interest rates will still act to reduce demand. Raising borrowing costs for consumers theoretically means they have less to spend on other goods and services. Just as importantly, it raises borrowing costs for businesses, reducing demand for investment and lowering profits. This lowers their ability to employ people or give inflation-busting pay rises. As demand falters, firms will find it harder to pass on costs. And as demand for labour falls, employees will be more cautious about ambitious pay rise requests.
However, the reduction in the proportion of households with a mortgage and rise in household savings means the impact of higher interest rates on households’ incomes is smaller than in previous hiking cycles. That will make interest rate rises less effective at dampening demand and suggests there is a larger role for fiscal policy to play in getting inflation back down to 2%.
The current problem
The supply side nature of the current problems causing inflation in the UK (from pandemic disrupted supply chains, to the surge in energy prices, and a shortage of workers) means that interest rates won’t be as effective in bringing down inflation as if inflation was being caused by an excess of demand.
What’s more, the aging demographic of the UK means around 35% of households now own their house outright, compared to around 25% in the early 1990s, and the proportion of households with a mortgage has dropped from around 40% to below 30%. That means that a large portion of households are now insulated from interest rate rises, which will blunt their effectiveness at reducing demand.
The mortgage issue
Probably the biggest issue is the changing structure of the UK mortgage market. In the early 2000s about 30% of mortgages were fixed, compared to above 90% now. That will have significantly lengthened the time it takes for interest rates to impact the economy. While the interest rate on new mortgages has creeped over 6%, the effective rate, which is the average mortgage rate paid, is still below 3%. This means higher rates will eventually lower demand, it will just take longer – perhaps 18 months – for rate hikes to impact the economy
The effect of the changes in the housing market are clear when we look at household interest payments. The combination of rising interest rates and increasing debt levels pushed households’ net interest payments up from around 5% of nominal disposable income in the early 2000s to almost 10% by early 2008. Over the same time, the amount households gained on their savings rose from about 3% of disposable income to about 7%, so interest rates represented a roughly 3% drain on households’ disposable incomes during the last tightening cycle.
In contrast, this time around households’ income from savings has risen more quickly than interest payments, because most savings accounts are floating rate whereas most mortgages are now fixed rate. The result is that households in aggregate are around £10bn better off because of the increase in interest rates.
Admittedly, this won’t last. As more people remortgage, interest payments will increase while income from savings will remain steady. The main problem is that those with a big stock of savings are also unlikely to have significant amounts of debt, such as mortgages. Given there are now almost as many households which have paid off their mortgages as those with mortgages, interest rate rises will make almost as many homeowners better off as worse off. As a result, the total drag of higher rates on aggregate household disposable income will be less than 1% this year.
That doesn’t necessarily mean consumer spending won’t be impacted, as higher interest rates are also an incentive to save. But it does undoubtedly blunt the effectiveness of interest rate rises.
If interest rates are less effective than previously, what does this mean for policy makers? One implication is that, in order to bring aggregate demand down, interest rates will have to go higher and stay there for longer than previously. This will heap more pain on those with mortgages and private renters and encourage those with savings to lock them away for longer or continue to save rather than spend the additional income.
An alternative or complementary solution would be for fiscal policy to do some of the heavy lifting. The advantage of fiscal policy is that the time lags can be significantly shorter, and it can be targeted to spread the burden of bringing down inflation across the whole of society rather than just those unlucky enough to have a mortgage or be renting. Not only would this be a more-effective way of reducing inflation it could also go someway to reducing wealth and income inequality.