On Thursday, the Bank of England raised the benchmark base rate for the first time in a decade. The modest 25bp increase takes the base rate back to where it was before the BoE reacted to its own erroneous forecast of imminent recession in the wake of last year’s Brexit referendum with a 25bp cut. The move comes as no surprise after BoE backed itself into a corner with a hawkish statement in September.
With inflation running at 3%, on the face of it a hike is no surprise. The MPC need to preserve whatever is left of credibility of the 2% inflation target and has indicated that two more 25bp hikes over the next two years will be needed to control inflation (it is laughable that an organisation with as miserable a record of economic forecast as the BoE comes up with such precise long-term policy prescriptions, but they do need to keep up an appearance of proactiveness and competence). But the Bank has ignored its own forecasts of inflation overshooting the 2% target since 2015 and the recent spike can be put down to the sell-off in Sterling since the Brexit referendum, so the timing of the move can be questioned.
It is difficult to see what the Bank hopes to achieve by this gradual path. Raising interest rates by 25bp does little to mitigate the miserable times enjoyed by savers or alter the economic calculation of entrepreneurs, but has the potential to undermine the leveraged household economies of squeezed JAMs.
After years of negative real interest rates, the UK is addicted to debt. Never mind that the government debt to GDP ratio is approaching 90%. Britons have a total household debt as a proportion of income of more than 140% (not as high as the 160% reached before the financial crisis) of which the vast majority is mortgage debt. The average mortgage now equals 3.4 times income. Of outstanding mortgages, around 40% are variable rate. The rest are typically fixed for between two and five years, so many will quickly come up for refinancing. A rate hike could mean immediate trouble for many property owners.
Contrast that with the US. The Federal Reserve has begun its tightening cycle without obvious immediate adverse effects. However, the US household debt to income ratio is significantly lower than in the UK, as is the average house price. Additionally, less than 10% of US mortgages are variable rate, with the average maturity close to 23 years, owing to the large proportion of 15 to 30-year fixed rate mortgages. The average American household is significantly less interest rate sensitive that the British.
The BoE is playing a dangerous game. Despite this, we welcome the rate hike – though we believe a much larger increase would be appropriate. We do not believe in price fixing, and short-term rates in a free money market would surely be much higher than the bureaucrats in the BoE deem appropriate. It is years of artificially low interest rates that has contributed to an economy addicted to debt, and the recession that is inevitable in the wake of any attempt to normalize rates is a necessary process to re-allocate capital to productive use and return indebtedness to sustainable levels.
The Bank of England is trapped by its own policy of ultra-low interest rates, which has allowed the UK to gorge on cheap credit and has seen house prices explode over the past decade despite slow economic growth and anemic wage growth. Exit strategy was always the difficult part of super-easy monetary policy, as we are about to find out. How long before the BoE will have to accept the reality of a recession or be forced to change course?