After getting used to a 0.5 per cent interest rate for over five years it is no surprise that there was a bit of shock when the Governor of the Bank of England seemed to imply that rates could rise by the end of 2014.
That is not much sooner than the first quarter of 2015 as markets had expected, but talk of any movement at all is big news. Rates can only go in one direction now that the economy is recovering, and a rate rise, however small, will affect large numbers of households.
The governor actually said : “There’s already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced. It could happen sooner than markets currently expect.”
Performance
But the comment was heavily caveated, with the governor reiterating that a decision will be based on the performance of the economy – and rate rises, when they happen, will be “gradual and limited”.
So is it too soon to expect a rate hike? Probably. There are still a large number of brakes on the economy – especially in the household sector.
As the latest set of minutes from the monetary policy committee reveal, there is just as much concern about stifling the recovery with a rate hike as there is that inflation will become entrenched without one.
And while the balance of risks is moving closer to a rate rise as things improve, that is not to say that one is imminent. Indeed, the MPC minutes reveal it needs to see more evidence of spare capacity being absorbed before the case for a rate hike became convincing.
It is clear there are conflicts – particularly in the housing market – where an increase in rates would undoubtedly have an effect on demand and the rate of house price growth. But there is a drawback because market froth is concentrated only in certain pockets of the market rather than across the board.
In addition, a hike in interest rates will not just affect new borrowers coming to market, but all the existing borrowers who are not in fixed rate products.
The latest data from the Financial Conduct Authority show that the proportion of outstanding balances on variable rates has been falling – presumably as borrowers understand that the next move in rates will be up – but the proportion is still more than 60 per cent, so most mortgage holders will face an increase in payments.
Even though any increases in rates are likely to be small and very gradual, the effect has to be seen in the context of what has happened to household finances since the recession.
While employment may have increased, a large proportion of that is self-employment, so it is unclear whether these workers are fully employed – and hence ‘fully’ paid. In addition, a large proportion of the workforce would rather be working more hours, real earnings growth has been negative for five years, and the cost of essentials such as utility bills and transport have increased faster than the general rate of inflation – further eroding households’ financial positions.
The question is therefore whether a hike in interest rates may have a disproportionately disagreeable effect on the housing market by increasing the numbers of borrowers in difficulty.
The decisions to introduce a three per cent interest rate stress test and a cap on loan-to- income ratio of 4.5 and over, leave us in no doubt about the Financial Policy Committee’s concern about further growth in mortgage-led household indebtedness.
The analysis in the latest Financial Stability Report recognises that while borrowers may be able to service high loan-to-income loans now and after a small rise in rates, those payments will take up an increasingly large proportion of income leaving borrowers and the economy as a whole, vulnerable to shocks.
Lenders have already used forbearance to help those on reduced incomes remain in their homes, but if interest rates rise and more borrowers get into difficulties, that policy may prove more difficult to sustain.
Indeed the proportion of loans in arrears with some forbearance agreement has increased significantly since the financial crash, showing the lenders’ sensitivity to risk, despite overall levels of arrears falling. A rise in arrears and possessions would also be a worry for the Bank of England. Wearing its prudential and financial stability hat, it has to beware of the impact on banks’ balance sheets of particular outcomes.
In the 1990s an increase in interest rates led to a huge increase in arrears and possessions, which put downward pressure on house prices and severely affected banks’ balance sheets as loans were written off.
Of course, there is no expectation that interest rates would be increased as much as back then, but it is worth noting that any increase in forced sales could have implications for the stability of the financial system if it imposed losses on banks.
Indeed the Financial Stability Report highlights that the latest proposals seek to provide insurance against a significant rise in the proportion of highly indebted borrowers, which will also increase the safety and soundness of firms.
Only in London have house prices risen above their 2007 peak, according to Land Registry data. Even though the size of mortgages taken out at the peak was on average about 80 to 85 per cent loan to value, in many parts of the country that still leaves a shortfall that the lender would have to bear in the event of repossession.
That loss could be increased further if we assume a discount to account for a forced sale.
Buoyant
Given that London has been the most buoyant market, borrowers who may get into difficulties as a result of higher rates would be able to trade out of their position, as would others in the more buoyant parts of the UK.
That would leave mortgage lenders with the adverse selection problem of being left with the properties and loans in areas where they are most likely to make a loss.
Of course this is what additional capital is built up to cushion against, but another hit to banks’ balance sheets when they are still recovering from the first would be difficult to swallow, and could do damage to financial stability – an objective the Bank of England is tasked to achieve.
Fionnuala Earley is residential research director of Hamptons International
Key points
Rates can only go in one direction now that the economy is recovering and a rate rise is inevitable.
It is clear there will be fallout as an increase in base rates will hit demand and the rate of house-price growth.
A hike in interest rates may have a negative effect on the housing market and the economy by increasing the numbers of borrowers in difficulty.
