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Cover story: Don’t panic!

The debate continues over when the Bank of England will raise the rate but for now the main feeling is keep calm and carry on  

Cover

Opinions continue to differ markedly on when the Bank base rate will rise and commentators are often finding themselves having to revise their forecasts in response to new developments. In August, for example, announcements made within only one week of each other contained quite contradictory messages.   

Data released on 13 August eased fears of a rate rise happening before the end of this year by showing that average weekly earnings grew by just 0.6 per cent in the three months to June compared with the same period a year ago.

“The inflation report was on the same day as the job numbers and the big connection between the two was how earnings growth was going to look,” explains Royal Bank of Scotland senior economic adviser Rupert Seggins. “The Bank of England had staked a lot on how the labour market was improving and the unemployment rate fell again to 6.4 per cent. But if you exclude bonuses, it was the lowest rate of wage growth since the Office for National Statistics started compiling stats in 2001.”

Only seven days later, however, news that the Bank’s Monetary Policy Committee had voted only 7/2 against a base rate rise saw rises this year once again being touted as a possibility. It was the first time for over three years that any member of the Committee had voted to increase rates.

Daniel Stewart & Co senior economist Alastair Winter is expecting rate rises as early as November. He feels the die was cast in June’s Mansion House speech when Bank governor Mark Carney warned rates might go up sooner than expected.“You can’t go on indefinitely with virtually zero rates because if rates are too low it starts distorting investment as people start taking excessive risks, so you have to get back to something normal,” Winter says.

On the other hand, Hargreaves Lansdown senior economist Ben Brettell is not expecting base rate rises until after the general election and, assuming this is held next May, he feels they will probably occur next July at the earliest.

“The lack of wage growth strongly indicates there is still some slack in the labour market and there is a convention that you don’t touch interest rates in the couple of months before an election as the Bank wants to be seen as independent and non-political,” he says.

Slowly does it                                                    

What really matters is the speed with which rates rise and the point at which they peak and no one is anticipating any real cause for alarm in either respect, especially with the Bank of England publicly stating that future rate rises will be gradual. It is generally agreed rates will rise via a series of 0.25 per cent increases and peak at somewhere between 2 per cent and 3 per cent by the end of 2017. 

This will mean they will remain significantly lower than at any time in the 10 years before the 2008 financial crisis, when they varied between 3.5 per cent and 7.5 per cent, spending most time in the 5 per cent to 6 per cent region.

Confidence in having such low rates for the foreseeable future has resulted from a general acceptance that inflation will remain low. Fears that quantitative easing programmes could result in a belated inflationary backlash have subsided on the realisation that banks have used the extra liquidity to bolster their balance sheets and the trend towards globalisation is also acknowledged as helping to exert downward pressure on prices.  

“The world has become so globalised that you can secure goods at the click of a mouse,” says Wriglesworth Consultancy director of business development and research Rob Thomas. “It’s very hard for companies to increase prices globally as consumers can shop around so, even if one economy is booming, it doesn’t lead to inflation in that economy as before because you can bring in labour and goods.”

The extent to which the rise in the bank base rate is likely to be translated into a rise in the mortgage rate is, however, subject to less unanimity. History shows the average standard variable mortgage rate rarely follows rises in base rates on a like-for-like basis. When base rates are low, lenders have tended to widen the gap and when they are high, they have tended to narrow it.

For example, with base rate currently at a record low 0.5 per cent, the average standard variable rate, as calculated by the Bank of England, was 4.36 per cent at 31 July – not far off 4 per cent above base rate. But at times when the base rate has been at 5 per cent the average standard variable rate has been at 6.73 per cent (June 1999), 6.7 per cent (November 2006) and 7.23 per cent (April 2008). The closest the base rate ever got in the 20 years prior to 2008 to the expected future 3 per cent maximum was 3.5 per cent in July 2003, when the average standard variable rate was 5.5 per cent.

Winter says he would be surprised if most variable rate mortgages moved much above 5 per cent if the base rate moves to 3 per cent while Thomas would also be surprised to see a rise of more than around 1 per cent in the average standard variable rate if the base rate reached 3 per cent. On the other hand, Seggins is not necessarily anticipating any dramatic narrowing of the spread between the two rates on the grounds that banks may need to maintain more margin and bolster reserves. 

But he points out that fixed-rate mortgages may rise at a slower rate than trackers. “Not all mortgages are priced off base rate. Fixed rates are priced off corresponding swap rates and at the moment the expectation is that the swap rate will rise more slowly that the base rate,” he says. 

How will it impact homeowners?

Mortgaged Future, a paper published in May by independent think- tank The Resolution Foundation, has predicted a rise in the base rate to nearly 3 per cent by 2018 is likely to put around 770,000 households both at risk of being mortgage prisoners due to a limited ability to switch to better mortgage deals and in danger of being highly geared, with monthly mortgage repayments eventually eating up at least one-third of their disposable income.

But the paper’s findings appear at odds with the general level of expectation within the mortgage field. In particular, the stress-testing introduced by the Mortgage Market Review in April  requires firms to consider the impact of likely future interest rates on affordability, paying attention to market expectations and any prevailing Financial Policy Committee recommendations.

In June, the FPC recommended that, when assessing affordability, mortgage lenders should apply an interest rate stress test that assesses whether borrowers could still afford their mortgages if, at any point over the first five years of the loan, the base rate were to be 3 per cent higher than what it was at the outset.

“With the MMR we have safeguards we didn’t have before. My view is that the majority of people taking out mortgages recently will have been stress tested on the basis of having to pay a mortgage rate of around 7 per cent compared with an existing one of somewhere between 2 per cent and 6 per cent,” says John Charcol senior technical manager Ray Boulger.

“In fact, most banks were already doing stress testing based on a similar margin for some years, so there is already slack built in. Provided that interest rates only move up slowly, we can all factor it into our thinking and I don’t think it will have much impact. Some surveys show people will struggle if interest rates rise up by 1 per cent but the reality is they will just cut back on something else. What would crucify the market would be a really sudden leap in rates, like when they doubled to nearly 15 per cent within 18 months in the late 1980s.”

Legal & General director of housing and mortgage club Stephen Smith says: “It’s not impossible that a gradual rise in base rates from 0.5 per cent to even 3.5 per cent or 4 per cent could be offset by cutbacks in discretionary expenditure, which tends to change according to the stresses that people’s finances are under.

“Activities like eating out and even fairly modest entertainment like going to the cinema could stop and, although things like Sky TV subscriptions and smartphone contracts could be among the last to go, I would expect their values to be questioned before people lose the roof over their head. There is no point in having a Sky broadband package if you haven’t got a house to put it in.”

Learning from history

Historical comparisons must clearly only be viewed in the context of the mortgage market today being a very different beast to the one that existed a couple of decades ago. Both the 0.5 per cent base rate and the exceptionally gradual proposed rises put us in completely new territory. So do the harder borrowing rules imposed by the MMR and the huge swing in the direction of fixed rates, which now account for 90 per cent of all new mortgages. Furthermore, the average first-time buyer now spends well under half the proportion of their gross income on mortgage interest payments than they did 25 years ago.

However, history suggests it may be unrealistic to expect even the modest and gradual anticipated rate rises to have no impact on mortgage business at all.

While the market has not seen any increases as large as the rises in 1988/9, there has been a few mini upward movements during a prolonged downward trend. For example, the base rate rose from 5.125 per cent in February 1994 to 6.625 per cent in February 1995, from 5.0 per cent in June 1999 to 6.0 per cent in February 2000 and from 3.5 per cent in July 2003 to 4.5 per cent in June 2004.

Lloyds Banking Group director of intermediaries Mike Jones has studied the reaction to historical base rate movements and observes that two things stand out very clearly. Every time the base rate is cut, there is an immediate reaction in terms of a growth in housing approvals and every time it rises, there is a reduction in housing approvals.

“Interest rate rises will slow or stop the growth of mortgage approvals but what is proposed by Carney is such a slow rate of growth that we actually have no comparative experience,” he says. “So I believe that, given the low base we are starting from, we will continue to see growth despite the rises forecast but that this will look modest compared with that of the last decade.”

In truth, however good or bad, the rate of growth in mortgage proposals that eventually materialises, it is always going to be hard to distinguish exactly how much is due to rising interest rates and how much is due to other factors. Experts already commonly express a hunch that the constraints imposed by the MMR are likely to have a bigger impact than rising interest rates and there are, of course, a range of other considerations to be taken into account such as consumer confidence, population growth, mortgage availability and the outlook for employment.

Furthermore, many of these factors are significantly interlinked. For example, both the level of interest rates and the outlook for employment can affect consumer confidence. Similarly, a decent level of wage growth can to a certain extent offset interest rate rises.

Yorkshire Building Society chief economist Andrew McPhillips says: “The outlook in the labour market is equally as important as rates and included in this is the impact on wages. As wage growth is low, higher rates could have more impact on people as they are more sensitive to them, which is part of the reason the Bank is saying it intends to raise rates so slowly. When the first rate rise is announced I expect it to dampen demand slightly but not to result in a huge shift. Already the housing market has been slowing down since about June in London and, although the rest of the UK hasn’t started to follow suit yet, it will catch up. But I’m not sure interest rates will have much to do with this.”

The here and now

Views on the state of the current market are in fact probably just as diverse as those on what could be lying around the corner. Indeed, surveys can throw up such a mishmash of different sentiments that the average prospective homebuyer could be forgiven for wondering whom to believe.

For example, an e.surv Mortgage Monitor survey produced in August revealed that the previous month, which played host to 66,279 house purchase approvals, was the best July for house purchase lending in seven years. Yet only a couple of weeks earlier the Halifax had produced a report detailing how most house buyers believed this was the worst time to buy a house since its series began in April 2011.

“The problem with a lot of surveys is that they are commissioned by people who want to engineer a certain answer,” Boulger explains. “How questions are phrased undoubtedly influences the answer, as does highlighting certain issues with previous questions, and putting questions on websites and asking people to answer involves a degree of self-selection. 

”Remember also that the expectations of people being surveyed are by and large driven by what they have read and heard via the media. So, if there has been a lot of media chatter about interest rates going up, then that’s what they will expect.”

Anecdotal evidence does not provide any less conflict of opinion either. For example, Penrith Building Society chief executive Amyn Fazal is adamant that he has not noticed any talk of the potential interest rate rises dampening demand. Indeed, he says, if anything, demand has increased during the last couple of months.

But London & Country associate director of communications David Hollingworth says it is not quite so black and white. “There is the odd piece of anecdotal evidence that homeowners who thought they could sell in an instant found that people weren’t exactly queuing up,” he says. “This is probably because buyers are worried about paying over the odds at this time.”

We will probably be no wiser on the exact impact that interest rate rises have had on demand for houses if and when the expected interest rises have peaked in four years’ time. As now, interest rates will continue to be merely one component of the overall jigsaw, albeit a very important one. 

Tombs

Capital Economics senior UK economist Samuel Tombs

Although the economic recovery now looks robust, it is hard to see why the MPC would have to raise interest rates sharply over the coming years. For a start, there is little evidence that the recovery is causing inflationary pressures to build. Consumer price inflation has been consistently below the 2 per cent target since December and looks set to ease to 1 per cent by the end of this year.

Admittedly, this drop will partly reflect the influence of temporary factors, including the recent fall in commodity prices and the decline in import prices in response to sterling’s appreciation. But domestically generated inflation looks set to remain weak. Wages have stagnated and are unlikely to grow at pre-recession rates while unemployment remains high by historical standards and many older workers cannot afford to retire. Meanwhile, the considerable scope for productivity to recover and so reduce firms’ unit wage costs suggests further strong gross domestic product growth may actually help to lower inflation.

The eurozone’s limp recovery will also keep a lid on UK inflation. High unemployment there will depress UK import prices and, through immigration, limit UK wage inflation. And with the European Central Bank on the cusp of loosening policy, sterling may continue to appreciate against the euro, pushing import costs down further.

Besides inflation, there are other reasons for the MPC to be cautious too. The severe fiscal squeeze is still less than half way through and household debt levels are still relatively high. Although a large proportion of new borrowers have fixed-rate mortgages, higher rates will still incentivise them to deleverage now so that they can cope when their existing deals expire.

Of course, the MPC will need to monitor whether low rates are propagating asset price bubbles, including in the housing market. But for now, another strong burst of house price inflation looks unlikely. A combination of macroprudential measures to restrict the supply of high loan-to-income mortgages and the looming prospect of higher interest rises has caused mortgage demand to stabilise while diminished expectations of house price growth have encouraged more homeowners to sell up.

Accordingly, while interest rates are unlikely to remain at their record low level of 0.5 per cent for much longer, there is every reason to expect their rise to be very gradual and limited. Indeed, we think they will only begin to rise early next year and will still be as low as 1 per cent by the end of 2015 and just 1.5 per cent at the close of 2016.

Further ahead, the MPC should be able to set interest rates at a level generally well below the 5 per cent average rate seen in the decade before the recession.

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