Key Insights for the Bank of England on Interest Rate Management
The upcoming budget is generating significant attention as we approach the deadline in three weeks. However, I want to shift the focus to another critical economic tool: interest rates as managed by the Bank of England. There appears to be an ongoing discussion within the Bank regarding the speed at which rates can decrease. A larger-than-expected reduction in US interest rates last month, coupled with an assertively dovish commentary from Bank Governor Andrew Bailey, has led markets to anticipate two additional cuts from the Bank’s Monetary Policy Committee (MPC) before the year’s end. Clearly, interest rates are declining.
This shift indicates that an unanticipated experiment—marked by a rapid increase in interest rates and the end of the prolonged period of near-zero rates—has entered a new phase.
Reflecting on headlines from past budgets, particularly the one presented by Liz Truss and Kwasi Kwarteng in September 2022, fears of a potential rise in rates to 6 or 7 percent sparked widespread predictions of a housing market collapse, with claims of impending «mortgage carnage.» Economic forecasts were similarly grim. Two years ago, predictions indicated the UK economy would shrink by approximately 1 percent last year, while the Bank itself forecasted the longest recession in history and a doubling of unemployment by 2025. Yet, these predictions did not materialize. Despite the Bank rate standing at just 1.75 percent in September 2022, it appeared that rates had a long way to climb. They never reached the feared 6 or 7 percent; instead, they peaked at 5.25 percent, narrowly halted from exceeding this by a 5-4 vote just over a year ago. A close vote also resulted in the first rate cut to 5 percent in August.
Historically, the housing market and broader economy demonstrated resilience beyond expectations. Instead of collapsing, house prices only fell by about 3.7 percent from peak to trough and have since recovered to levels surpassing those from two years ago. Indicators of housing activity, like mortgage approvals, are also showing a robust recovery that persists.
In terms of the economy, there was a mild «technical» recession at the end of last year, characterized by two consecutive quarters of declining GDP. However, the overall growth for the year remained at 0.3 percent, rather than the projected drop of 0.9 percent or worse. The anticipated lengthy recession predicted by the Bank did not occur, and economic performance this year has also exceeded expectations.
What factors contributed to this outcome? Interest rates ultimately increased, but not as markedly as some had feared two years prior, despite a significant rise. The panic triggered during Truss’s tenure was supplanted by what Jeremy Hunt and Rishi Sunak considered prudent economic governance. The presence of two chancellors helped stabilize concerns. Concurrently, housebuilders proactively managed the situation by scaling back supply, resulting in the lowest housing completions during the early months of this year since 2016.
The experience during this phase of elevated interest rates illustrates that the economy weathered the turmoil surprisingly well. The anticipated fallout did not materialize as expected. The impact of interest rate increases was profound. For over a decade, from March 2009 to May 2022, the Bank rate rarely rose above 0.75 percent. Transitioning back to normalized rates demanded a considerable uptick.
This experience highlights several crucial insights. First, the so-called transmission mechanism that connects increasing official interest rates to the broader economy has evolved. Previously, a rise in interest rates had an immediate effect on borrowers, as most mortgages were on variable rates, leading to swift increases in payments. This pattern held true for many businesses as well. Currently, however, the landscape is predominantly characterized by fixed-rate borrowing, allowing more time for individuals to adjust to higher rates. For example, anyone who secured a fixed mortgage in 2021 may not need to renegotiate until 2026. Consequently, the impact of rising rates is more gradual than it was previously, although much of this effect is now being felt.
Another noteworthy change arises from the evolving structure of the housing market. Historically, most owner-occupiers had mortgages; however, today, less than half do, with older homeowners more likely to own outright. This shift means that the burden of higher interest rates is now concentrated among a smaller percentage of individuals. Those who own their homes outright are generally more financially secure, with savings that benefit from increased interest rates. For business borrowers, the effects of higher rates were further complicated by the lingering impact of COVID loans from the pandemic.
The primary lesson here is that until inflation forced the Bank and other central banks to enact rate increases, they were overly cautious in their approach. This observation does not imply that the Bank should have raised rates at the height of the pandemic in 2020 or even earlier in 2021, but rather that they should have taken action much sooner in the preceding years. Normalizing interest rates during the 2010s would have been a more prudent course of action.
There were numerous opportunities to implement such changes after the financial and eurozone crises had subsided in 2014 and 2015. Indeed, when Mark Carney became Bank governor, he established a system of «forward guidance» indicating that rates would rise once unemployment dropped below a certain threshold. Though unemployment did fall, rates were not adjusted upward. Had this normalization occurred earlier, more flexibility would have existed to make cuts when the pandemic struck, mitigating fears associated with prolonged low rates. It is crucial that we do not repeat the error of maintaining excessively low rates for extended periods in the future.
David Smith serves as the Economics Editor for The Sunday Times
