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22 September 2022

Why the UK is vulnerable to high interest rates

Britain does not want the fever of inflation – but it is unprepared for the cure.

By Will Dunn

The Bank of England has raised interest rates today (22 September) by half a percentage point to 2.25 per cent, the highest level since rates were aggressively cut to stabilise financial markets in the autumn of 2008. In doing so it will help to cool inflation, which is now at 9.9 per cent, but it will also add billions to the nation’s mortgage payments and begin in earnest the fight that has long been brewing between a central bank that is required by its mandate to dampen inflation, and a government that is required by its voters to avoid recession.

At the beginning of this year, the New Statesman warned that Britain was more exposed than other countries to the inflation that had rapidly begun to take hold in supply chains, energy and some parts of the labour market – and which would be supercharged, several weeks later, by Russia’s invasion of Ukraine.

But while Britain does not want the fever of inflation, it is also unprepared for the cure. Rising prices have already led to strikes among unionised workers and desperation among those on lower incomes. High interest rates are about to make things even more uncomfortable.

If a central banker is at fault for this predicament, however, it is arguably not the current Bank of England governor, Andrew Bailey, but his predecessor, Mark Carney. In March 2009, the Bank slashed the official interest rate to 0.5 per cent, and it was kept below 1 per cent for 13 years. This made the payments on large mortgages historically low, which made houses historically expensive (by 2019 houses were as unaffordable as they had been in the late Victorian era, when the popular solution to the problem was to live in someone else’s house as a servant), while also making it historically cheap to buy a house that you couldn’t really afford. Everyone knew this was a terrible idea.

The same was true for the next biggest household expense: the car. Car prices, like house prices, have dramatically outpaced inflation: the average new SUV now costs 121 per cent of median household disposable income.

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In an economy with sensibly priced debt, the reaction to this would be an elderly Volvo in every driveway, but in a Britain drunk on cheap debt and financial innovation, millions of people invested in a Nissan Qashqai, an SUV that costs from 82 per cent of median yearly disposable income but can also be driven away for about £250 a month. Just as it did with houses, cheap debt made cars much more achievable and much more expensive.

This has led to an economy in which household debt equals 90 per cent of GDP, of which the biggest component is a total value of £1.63trn in mortgages. From comparable economies in the EU and US, only the Netherlands has more household debt – and this is not because the Dutch are shopaholics, but because they can write mortgage interest off their income tax.

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The Dutch also fix their mortgages for long-terms – often 20 years – as do the Americans, Belgians and many others. British household debt, by contrast, gets repriced on a regular basis. The finance deals used to buy more than 90 per cent of Britain’s cars mostly end after three years, while a third of British mortgage holders will need to find a new fixed rate within the next two years. British consumers are about to spend billions more, not on goods or services, but on debt.

It’s not just how we spend our money, but how we make our money, that makes the UK vulnerable to a new world of interest rates. The Bank of England warned last November that of the British small-to-medium businesses that have any debt, a third had more than ten times as much debt as they had cash on their balance sheets.

Nor are British workers well prepared for a sharp rise in costs when inflation (at 9.9 per cent) is dramatically outpacing wage growth; when real wages are forecast to remain below 2008 levels until at least 2026; and when apparently full employment masks the underemployment of large numbers of workers (3.3 per cent of the workforce) stuck in part-time, zero-hours or gig-economy work who are not able to secure more hours or a full-time job.

Britain’s economy is also heavily dependent on services, particularly financial services. In a time of rising interest rates, some aspects of banking will become more profitable; if a bank can charge its customers more for their debt, its returns will be higher. However, its costs – for example, wages and the cost of borrowing from other banks – will also be higher. Perhaps more significantly, higher interest rates also change the value of the assets that banks might invest in. During the years of next-to-zero interest rates and quantitative easing (QE), there was a lot of cheap money going around that could be thrown at speculative investments such as fast-moving tech companies, fuelling lucrative activities such as new company listings (initial public offerings, or IPOs), mergers and buyouts. When interest rates rise, money becomes more expensive, market participants become more cautious and financial institutions lose revenue.

This may be why Liz Truss and Kwasi Kwarteng are happy to take the apparently unpopular step of removing the cap on bankers’ bonuses, which was imposed by the EU after the financial crisis. Bumper bonuses were part of the culture that caused the crash because they hand the biggest reward to the person who most effectively maximises their risk. Limiting them is supposed to limit the rewards from risk-seeking behaviour and create more stable financial markets. It could be argued that such measures were always flimsy, because banks easily find other ways to pay what they like, and for that matter irrelevant, because the trillions pumped into financial markets by QE had a far greater effect on promoting risk than any bonus. But lifting them the day after a historic rate rise does look a lot like a message from government that, even as the cost of playing rises, it still believes the City can gamble its way to growth.

Ultimately, it is this ideology – that deregulated, detaxed growth is the answer to our predicament – that could now be the biggest weakness when it comes to dealing with higher interest rates. It commits the government to inflationary measures, such as borrowing huge sums from financial markets (which can affect the value of the pound, making imports even more expensive), and subsidising energy use to the tune of at least £150bn, and cutting taxes for the highest earners, which actually stimulate demand in the middle of a once-in-a-generation supply crisis.

Perhaps tomorrow Kwarteng will offer a perfectly reasonable explanation for these policies. Perhaps the plan is to give so much money to people on six-figure salaries that they all decide to spend the winter in the Maldives, and the nation’s Agas go unlit for a season. Or perhaps the government thinks that when the pain of high interest rates arrives, it can safely be blamed on the Bank, and voters will accept that a brave, growth-hungry government is doing what it can, while the unelected mandarins of Threadneedle Street squat toad-like upon the economy. Some voters will buy that, but doing so will come – like everything else in the higher-interest world – at a price.

[See also: The Truss government is planning to make the rich richer]