Stop cutting the base rate

Adrian Coles, director-general of the Building Societies Association, argues that increasing mortgage availability rather than reducing interest rates will lead us out of the economic mire

Many commentators have highlighed the low level of interest rates as one of the key differences between this downturn in the housing market and the downturns of the early 1980s and 1990s.

In November 1979 the Bank of England base rate – then called minimum lending rate – was increased to 17%. The figure stayed in double digits from June 1978 until June 1983 with one brief interlude of a single month.

In the recession that began in 1989 Bank base rate again rose sharply, reaching a peak of 15% in October 1989 and remaining there for a year. During that period we had double-digit interest rates from July 1988 to September 1992.

Of course, we entered the earlier recessions with much higher levels of inflation but the contrast with the current cycle remains notable.

Interest rates have been cut aggressively and reached the lowest point in the Bank’s 315-year history with the Monetary Policy Committee announcement on January 8 that the repo rate would fall to 1.5%.

Many are calling for further reductions in interest rates but it is not at all clear that this would help either savers, borrowers or the mortgage market.

Reductions in interest rates have what is now recognised to be a severe impact on savers. The earlier reductions from the 5% rate in place until the early autumn of 2008 evoked little sympathy for savers, with much media and political comment encouraging lenders to pass on interest rate changes to borrowers and little mention being made of savers’ interests.

However, the reduction in early January was more controversial, with many commentators drawing attention to the situation faced by older people who had saved all their lives but now faced a sharp reduction in their living standards.

Some argued that with the rate of inflation falling – prices as measured by the Retail Price Index rose by just 0.9% in the year to December 2008 – interest rates were still positive in real terms.

But this argument did not play well with savers who have seen their incomes fall if their savings were in an account broadly tracking the base rate down from 5% to 1.5% in the past five months.

When your income has fallen by 70% it’s not much consolation to be told that prices are rising more slowly. For the many pensioners who depend on their interest income prices would need to fall by 70% for them to be able to sustain their living standards. This is, of course, unthinkable.

Variable rate mortgage borrowers have so far been the winners from recent trends in interest rates. Many borrowers have seen their mortgage payments more than halve and have substantial extra funds available for spending, saving or repaying debt.

Surely this is beneficial for the mortgage market? The answer is yes, but within limits.

Our regular market research in the housing market shows that interest rate policy has been effective in increasing the affordability of housing in the past few months.

The research shows that in June 2008 70% of respondents saw affordability of monthly mortgage payments as a barrier to buying a home. By December that figure had fallen to 37%. Clearly, this is due to a combination of falling property prices and falling interest rates.

However, there was little change in the percentage seeing access to a large enough mortgage or to a mortgage at all as a barrier. In June 2008, 49% of respondents mentioned this as an issue and that figure had increased only slightly to 56% by December 2008.

So it is mortgage availability rather than the cost of mortgages that is now the key issue. This suggests that what is important to potential borrowers is maintaining the flow of mortgage funds rather than reducing rates of interest further.

A further reduction in interest rates would have an even greater impact on savers, making them less likely to invest in building societies and disrupting further the flow of funds into the mortgage market, which is already significantly short of lending potential.

The government recently announced it is no longer demanding that Northern Rock repays its outstanding loans as quickly as possible. Rather, it said the Rock’s aim should be “to support government policy to increase mortgage lending capacity”.

If we have a policy of increasing mortgage lending capacity, reducing interest rates further is not the way to deliver this. Rather we need to ensure that consumers in that sector of the economy with at least some capacity to supply mortgage lending funds – personal savers – are encouraged, and that means at least maintaining the present level of interest rates.