Farewell to cheap money – Reaction


A personal perspective from Ian Stewart, Deloitte’s UK Chief Economist.

The war in Ukraine and rising energy prices have pushed inflation to double digit levels in the UK, the highest level in 40 years. Uncertainty over future Russian gas supplies, highlighted by the indefinite shutdown of Nord Stream 1 this weekend, means we now expect UK inflation to rise further, peaking at around 16% next spring. Despite a decline thereafter, the inflation rate could still be in high single digits at the end of next year.

Higher inflation implies higher interest rates. Financial markets have revised their interest rate expectations significantly upwards since the beginning of August. The UK base rate stands at 1.75% today, down from a low of 0.1% last December. Markets expect the base rate to top 3% by the end of this year and peak at 4.3% next summer, bringing rates down to levels not seen in 2008.

The Bank raised rates to cool an economy it says is growing too fast. Higher rates increase debt servicing costs for households, businesses and the government and dampen demand for new credit. Taken in isolation, higher rates also tend to weigh on asset prices, especially when associated with lower corporate revenues or profits.

The UK is in a recession, with consumer balance sheets overall looking quite strong. Levels of household debt relative to GDP have remained broadly stable over the past five years and are well below levels between 2006 and 2010. At the same time, household deposits are at record highs, reflecting how households saved during the pandemic. But that’s just a snapshot of a point in time. The question is what effect high interest rates and inflation, and ultimately a weaker labor market, have on household balance sheets.

The bulk of outstanding household debt in the UK, around 70%, is held in the form of mortgages. This debt is unevenly distributed across the population, with only 30% of the population having a mortgage. (About 35% of the population owns mortgage-free property. The remaining 35% of the population rents, split roughly evenly between the private and social sectors.)

Over the past 20 years, an increasing number of borrowers have taken out fixed rate mortgages, which means that increases in the Bank’s base rate trickle down to mortgages more slowly. mortgage holders than previously. Among the 30% of the population with a mortgage, around a third are on variable offers whose rates have already increased. About two-thirds of mortgagors are on fixed rates, typically for two or five years, and are insulated from the immediate effects of rate increases. It will take three years for just over half of the current outstanding fixed rate mortgages to mature.

However, rising mortgage rates also come through other channels, including dampening demand for mortgages and real estate transactions and their effect on house prices. (Real estate activity in the UK has held up so far, although in the US house sales and new housing starts have fallen sharply. The US price of timber, an input basis for new homes in the United States, has fallen nearly two-thirds since March.)

Interest rate hikes have their greatest effect on segments of the population with higher incomes, but not much more universally. The direct effect on low-income households is more muted because they have low levels of debt, particularly mortgages.

Rising interest rates create a tougher environment for risky assets, such as stocks, which have benefited from years of easy money. The reset of interest rate expectations last month, in the United States, the United Kingdom and the euro zone, led to a sell-off in equities, the United States S&P500 down almost 10% since mid-August and the Euro Stoxx 50 and FTSE 100 down around 5%.

Interest rates on unsecured personal loans and credit cards are largely determined by personal credit risk and less directly related to the Bank’s base rate than mortgage rates. So far, they have shown only a modest response to rising rates. That should change if, as seems likely, distress levels in the household sector increase as the economy weakens.

On the other side of the balance sheet, consumers are also savers. The benefits of higher rates for this group have been limited so far. Interest rates on instant access accounts, which account for two-thirds of all household deposits, saw minimal increases. The fact that savings rates have risen little suggests that banks have few problems attracting deposits. (Rising bank lending rates, with deposit rates broadly stable, are helping to support bank margins.)

The corporate sector is more directly exposed to the impact of higher interest rates than consumption, with small and medium enterprises being the most dependent on bank loans. About three quarters of outstanding corporate bank debt is floating rate and most corporate borrowers have seen an increase in the cost of servicing existing funding and raising new funding from banks. Bond markets have also reacted, with yields on investment-grade UK corporate bonds more than tripling since last November and now approaching levels last seen after the 2009 financial crisis.

Inflation and monetary tightening also have an effect on the cost of public debt. Short-term borrowing costs, which tend to move in line with base rate expectations, rose sharply as two-year gilt yields hit a 14-year high last week. Last month’s FT analysis suggested government debt servicing costs are set to nearly double from £50bn to £95bn next year – and that’s before any further aid. With a new Prime Minister taking office today, markets are also looking closely at the nature of the fiscal support likely to be provided to households. A large, less targeted set of measures could be seen as aggravating inflation-related risks and, therefore, forcing the Bank to maintain higher interest rates for longer.

Overall, household and corporate balance sheets appear to be in reasonable condition. Yet this high-level generalization masks the fact that debt is unevenly distributed between households and businesses. So far, the slowdown in economic activity has been driven by high inflation. Rising interest rates are likely to add a growing drag on activity from here.

PS: No one knows how post-pandemic work arrangements will unfold, but two recent reports provide useful insight into the situation in the United States. Nicholas Bloom of Stanford University estimates that the share of paid full days worked from home is stabilizing at around 30%, compared to a peak of 61% during the first confinement. This represents a sixfold increase in working from home compared to pre-pandemic levels. For those who can work entirely remotely, there’s good news from the Tracking Happiness Project’s large-scale study of wellbeing and remote working. It found that the ability to work entirely remotely is associated with a 20% increase in self-reported happiness. Younger workers, especially those in the Gen Z and Millennial cohorts, are most likely to benefit. Research indicates that the key factor for improvement is no daily commute, a commute associated with lower levels of happiness.

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