02 November 2003 17:33
Outlook: Britain takes a hit in the wallet
SO, FAREWELL, then, Great Consumer Boom 1995-2003. This boom shrugged off the Russia crisis, the Asia crisis, a
change in government, the dot.com boom and bust, two-and-a-half years of falling share prices and a slump in the values
of ISAs and endowment products.
>From this week it will be different. On Thursday the Bank of England's Monetary Policy Committee is set to
confirm what has been under way in the money markets for some time and raise interest rates. It will be the first such
increase for more than three years. The popular expectation is of a 25 basis points rise to 3.75 per cent. Some are not
ruling out a half point hike.
But how could such a small fractional rise trigger a big change in borrowing and spending habits? After all, a
quarter point on interest rates is surely neither here nor there.
Unfortunately for many households it is much too "here" for comfort. The fractional change in the rate
hides a very large rise indeed in monthly outgoings for millions of borrowers. This is because a rise in interest rates
will have a greater effect at low levels than when rates are higher.
Consider this example. With a rise in interest rates from 7 per cent to 7.5 per cent the rise in debt service costs
is 7 per cent. But the same increase (that is, 0.5 per cent) from 3.5 per cent to 4 per cent raises debt service costs
by 14 per cent. Similarly, a rise from 3.5 per cent to 5.5 per cent - a rate level thought likely by many 12 months on
from now - raises the debt servicing burden by 57 per cent.
Looked at this way, tens of thousands of home owners who have borrowed heavily in the past few years could be staring
at bankruptcy. Not only would consumer spending be reined in abruptly, but housing demand would take a big hit. A fall
in house prices of between 20 per cent and 25 per cent would not be at all fanciful. Hopefully, long before this is
reached, there would have been a most salutary effect on consumer borrowing and spending, strong enough to stay the
MPC's hand at or near 5 per cent.
It is the interplay of these two factors - the impact on net monthly outgoings and the likelihood that this
week's rise will not be a "one-off" but the first in a series of rises over the next 12 months - that is
set to change the climate of spending and borrowing by households. I will set aside for now the possibility of any
further increase in taxes that would compound the effect.
Even so, it is hard to overestimate the likely impact of this change in the rate cycle. For the best part of a decade
the long arc of interest rates in the UK has tended down. As rates fell domestic demand rose - rather slowly in the mid
1990s due to tax increases. But in the second half of the decade the consumer boom really took off. Behind this shift
has been a truly explosive rate of increase in personal sector borrowing. Despite hopeful predictions to the contrary,
this rate has shown no sign of deceleration as house prices rose even further into the stratosphere. Indeed, the figures
that look to have set the seal on a rate rise were latest data on personal borrowing released last week. Personal
borrowing rose by GBP 10.7bn (1.2 per cent) month on month in September, the latest in a series of record monthly
increases in credit. The year on year rate edged up to 14 per cent from 13.9 per cent in August.
There is no sign that this credit boom is fading. The value of mortgage commitments rose to GBP 30.9bn in September -
yet another record high. Michael Saunders, UK economist at Citigroup, puts this in truly dramatic context: "When
the MPC became independent in 1997, mortgage commitments averaged GBP 6.4bn per month. They averaged GBP 7.6bn in 1998,
GBP 9.8bn in 1999, GBP 9.9bn in 2000, GBP 13.7bn in 2001, GBP 19.3bn in 2002 and now have risen by a further 60 per cent
to GBP 30.9bn." Put simply, mortgage commitments have trebled in just three years.
Equally, a much hoped-for moderation in house prices has been slow in coming. The rate of house price inflation did
indeed ease back from its peak at the turn of the year (26.5 per cent according to the Nationwide). But latest figures
suggest it has stopped falling. Figures last Friday from the Nationwide showed that the annual rate of increase had
stepped up again, from a modest 15.5 per cent rate to 16.1 per cent in October.
It is thus hard to see how the MPC can avoid putting up rates this week, the first of the major Western central banks
to do so. But whether this will be a one-off or the start of an aggressive rate-rising phase will need to await market
reaction over the coming weeks. One can understand how mortgage borrowers might be nervous. In previous upward cycles,
such as between 1988-90, interest rates rose from 7.5 per cent to 15 per cent. In 1996-98 they rose from 5.75 per cent
to 7.5 per cent.
It is at this point that the doves and the hawks part company. The doves point out that the UK economy is not
booming. Growth was only 1.9 per cent in the year to the third quarter of 2003 - still below long-term trend - and
manufacturing output has stagnated in the last year. Douglas McWilliams, chief executive of the Centre for Economics and
Business Research, argues that once the rate of house price growth drops to 5 per cent or so, the core inflation rate
should fall back below its 2.5 per cent target.
He also reminds us that the chancellor is about to change the Bank's inflation target to one based on the
European harmonised index of consumer prices. This is only 1.4 per cent at present, "and the Bank's
challenge", says McWilliams, "will soon become how to get HICP inflation up to a target around 2 per cent
rather than how to get it down. It may even have to reduce rates next year." But others see a rise next week as
part of an extended tightening cycle that will carry base rates up to 5-5.5 per cent over the next 18 months. The
continuing surge in house prices, mortgage lending and mortgage commitments shows how loose monetary policy is. A
pre-emptive approach - that is, raising rates now before there is a serious breach of the inflation target in prospect -
should help make subsequent rises less frequent and steep than they might otherwise have been.
As for overall economic performance, it is likely to strengthen with the continuing recovery in world trade and in
particular with the growth surge in the US. The present somewhat pallid rate of growth belies better prospects next
year.
In truth, much depends on how UK households react in the coming weeks. Previous experience - in particular the period
1998-1999 - suggests that reaction to a strong of rate increases can be slow and modest. But the pain this time should
be more immediately felt.
The likely response of mortgage lenders will be to follow with a half percentage point increase. And the impact on
households already hit by higher National Insurance and council tax bills of a notable rise in mortgage interest
payments should be salutary. The great consumer spending boom is heading at last for a spell in the freezer.
[UKIR [UK & Ireland Intelligence Wire]] |
RUSSIA IN FACTS
