The implication of the Bank of England’s new assessment of household indebtedness is that a modest rise in interest rates would not sink the economy, but would be acutely painful for hundreds of thousands of people.
So on a day when many are asking why a rich country such as the UK has a growing need for food banks, it is the social implications of inevitable increases in interest rates that may be more important than the economic effects.
The most striking statement in the Bank’s new debt analysis is that “gradual increases in interest rates from their current historically low levels” should not “have unusually large effects on household spending”.
This is slightly odd – which is why the Bank of England is quick to point out that it is not the official view of the Bank’s Monetary Policy Committee, but is the view of Bank officials who “feed in” to the MPC’s decision.
The reason it is a bit counter-intuitive to say that interest rate rises won’t have a magnified effect on spending and the growth of the economy is that the indebtedness of households remains high by historic standards.
According to the Office for Budget Responsibility, household liabilities are 146% of household income, which is 20 percentage points below its peak at the end of the boom years, but 30 percentage points above where it was in the 1990s.
The UK, and especially its consumers, remains massively indebted.
So any rise in interest rates should have an enlarged effect on how little indebted people have available to spend. And that indeed has been the official position of the Bank of England.
Why might the Bank want to change its official position and be less fearful of rate rises?
Well, there are two reasons.
One is that “only” 57% of those with mortgages told the Bank of England that they would cut their spending if interest rates rose two percentage points.
In the survey of 6,000 households carried out for the Bank by NMG Consulting, some 35% said they would simply save less if rates rose 2%, while 24% said they would work more or find other ways to boost income from employment.
And in bad news for the banks and building societies, 23% said they would request changes to their loans – which is another way of saying they would change the repayment profile to the detriment and cost of the lender.
Or to put it another way, a rise in interest rates would potentially generate significant losses for banks, if the survey proves to be correct.
The second reason why a rise in interest rates might not stymie the economy is that savings have increased since the 2008 debacle. And if interest rates were to rise, savers’ income would rise.
However, the survey suggests that savers will spend just £1 for every £10 increase in their income, whereas borrowers will cut their spending by £5 for every £10 of their income drop.
Even so, the Bank calculates that a 2% rise in interest rates would reduce spending by around 1% – which, apparently, is not massively out of whack with historical norms.
All of which is to say that the Bank does appear to be steeling itself for the effects of an interest rate rise, because it knows one is likely to be necessary next year – and maybe earlier than the autumn date anticipated by investors.
None of which is to play down the hardship for many people that may be caused by a rate increase.
There are still 4% of those with mortgages, little changed from last year, who pay out 40% or more of their gross income to service their debts. That is 360,000 people who are at significant risk of not being able to keep up the payments – and who have precious little money left after shelling out for interest and principal.
That is 1.2% of all households, which – as it happens – is very much at the low end of where this measure of financial distress has been since 1991.
But UK households are still very indebted by all historical standards. The share of households with a mortgage debt-to-income ratio above 3 is still high by historical standards, at 5.8%, compared with less than 3% during most of the 1990’s. But that proportion of fairly highly indebted households has come down from a peak of 7.64% in 2011.
So how can debt distress be relatively low? Well, it is because – as if you need telling – interest rates have been at record lows since March 2009.
One important question, therefore, is what would happen to the number of people in financial distress if interest rates were to rise?
Well, the Bank tries to answer this question for a two percentage-point rise in rates, combined with a 10% rise in income for all households or a 0% rise in income for all households.
By the way, there is no magic to the 2% assumption. Interest rates may rise by more than this or less than this over the next two to three years.
But given the sheer magnitude of debts bearing down on the UK economy, it is reasonable to assume that the Bank of England would not wish to raise interest rates by more than two percentage points over the coming few years, for fear of mullering us all.
So here is the thing.
If the income of households were to rise 10% before the rate rise, the proportion of those in distress would rise by 50%, from 1.2% of households to 1.8% of households.
And the actual number in this vulnerable category would rise from 360,000 households to approximately 500,000 (I know these numbers aren’t consistent – but there is lots of rounding of numbers and percentages going on at the Bank).
Which is a big increase in financial pain. But even 1.8% of households classified as vulnerable would not be particularly high by recent standards.
That said, the proportion in this distressed group would increase to 2.4% of households, in the scenario of interest rates rising without a prior increase in incomes. And 2.4% would be a high proportion in distress by historical standards.
Now it is unlikely that the Bank would raise interest rates by 2% if incomes had not risen in general.
However, the most vulnerable households are those that are most pessimistic about their wage and salary prospects.
And if they happen to be in low or intermediate skilled employment, or part-time employment, they may be right to be pessimistic – since prospects for earnings growth in this part of the labour market are widely seen as depressed.
All of which suggests that interest rate rises, as and when they come, may not destroy the economic recovery, but they may wreck the lives of many families.