For four decades Jonquil Lowe, Senior Lecturer in Economics and Personal Finance at The Open University, has scrutinised the performance of our economy under successive governments. Now she sets out with crystal-clear clarity, that if the banks help savers we all might benefit.
We’re in a monetary quagmire. Mortgage holders are already struggling with higher costs as they near the end of their fixed deals but High Street banks are failing to pass on base rate increases to savers.
That’s not just a matter of economic justice; it may contribute to bringing inflation down. So, has the Bank of England done enough or must interest rates go higher?
The answer is interest rate changes take time to have an effect, but because the government has racked up big debts that need servicing via gilts, this brings pressure from international markets for further interest-rate hikes.
To unravel what’s going on means understanding a little about how monetary policy is supposed to work.
Imagine the economy is a tyre that needs to be kept at a steady pressure (the inflation target of 2% a year). This will increase if someone is pumping it up – that’s like demand-pull inflation where too much demand (spending) in the economy pushes up inflation.
What it will take to stop inflation
The obvious solution is to stop pumping in more air (spending). But the tyre will still be over-inflated so the only way to bring inflation back down is to let out some air.
But if the pressure increases just because the tyre gets hot – that’s like cost-push inflation, where external factors like the war in Ukraine have caused prices to rise.
If the pressure in the tyre is too high, the only way to bring it down is to let some air out (even though it was not added air that caused the initial problem).
Whatever the cause, the way to bring inflation down is by reducing demand in the economy. That means deliberately creating a mini recession.
What happens when base rates are not passed on to savers
The conventional way monetary policy deflates the economy is by increasing interest rates and two key ways that works are through borrowing and saving.
Higher interest rates increase the cost of borrowing, deterring firms and households from new borrowing to invest or spend.
It’s more expensive for existing borrowers, especially mortgage holders with large loans, so they have less to spend (which lets more air out of the tyre).
Clearly, there are benefits to those who can afford to save (which lets out more air) because as saving goes up, spending falls, but that route for monetary policy becomes blocked if commercial banks fail to pass on base rate rises.
The Financial Conduct Authority (FCA) recently called in bank bosses to explain their tardiness in passing on rate rises to savers, and it looks like part of a collective effort by the authorities to ease blockages in monetary policy.
Rates might already be high enough
In the late 1990s, the Bank of England estimated that it takes about 18 months to two years for a rise in the base rate to bring down inflation.
These lags mean there’s nothing the Bank can do to alter inflation today. Instead, with the aid of forecasts, it aims to manage inflation a couple of years ahead.
So, it is possible that the 4.9 percentage point rise in the base rate since December 2021 might already be enough to curb inflation – a view held by two members of the Bank’s interest-rate setting committee.
But the time lag may be even longer than two years. In 1999, just over a third of new mortgages were on a fixed rate (Council of Mortgage Lenders, 1999), so base rate changes quickly rippled through to the variable rates most people were paying.
Today, 83% of new mortgages have a fixed rate typically for periods from two to five years. Base rate changes only impact those mortgages once the fixed term comes to an end and the borrower has to find a replacement loan.
Home owners remortgaging will bear the pain
The Resolution Foundation has estimated that there are 900,000 fixed rate mortgages maturing in the second half of 2023 and another 900,000 during 2024.
Someone who took out a two-year fixed rate loan for £150,000 in 2021 can expect to see their annual payments jump by £4,000 when they remortgage at two-year fixed rates of around 6.5% (Moneyfacts) in July 2023.
At the turn of the century, 41% of households had a mortgage (Social Trends, 2003). Today the proportion is only 29%, so the pain of monetary policy is now concentrated on a smaller proportion of the population.
This may be reducing the effectiveness of conventional monetary policies as well as increasing the injustice that borrowers feel and many mortgage holders will end up struggling to meet their payments.
If you are affected, talk to your lender. Under a temporary arrangement brokered by the government and more permanent measures being proposed by the FCA, lenders should do everything they can to prevent you losing your home. This could include extending your mortgage term or switching to an interest-only loan.
If you are claiming means-tested benefits, such as Universal Credit, you may be able to claim Support for Mortgage Interest, which provides help paying the interest (but not any capital) on your mortgage in the form of a government loan secured against your home.
The government and FCA measures to help borrowers may limit the size of the expected fall in house prices, by reducing the number of home repossessions.
These were a major factor in the 20% fall (Nationwide data) in house prices that resulted from the last major curbing of inflation back in the 1990s.
Why pressure from international markets is significant
Following the 2008 Global Financial Crisis, the 2020 pandemic and support for households during earlier stages of cost-of-living crisis, government debt is now high at 102 per cent of national income.
Most of that borrowing is in the form of government bonds (gilts). As old gilts mature the government must sell new gilts to replace them.
In the financial markets where gilts are sold, the return that investors expect depends crucially on whether they are confident that UK inflation is under control (as was clearly seen during the short-lived Kwarteng-Truss tax-cutting Budget in September 2022).
The markets are signalling that they think the Bank has not yet done enough and base rates need to climb further (and these market rates further push up the mortgage rates households pay).
The Bank may decide to raise the base rate further, regardless of whether the cumulative rate rises will in fact turn out to have let enough air out of the tyre. And that increases the risk of a recession that is deeper than the UK needs to get inflation back on target.
But any signs the economy has started to weaken might be enough to stay the Bank’s hand and reverse financial-market sentiment.
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