Bloomberg / London
The Bank of England (BoE) is being warned it may have to hike interest rates higher than investors expect, even as the risk of recession mounts, in part because it has lost much of its power to control inflation.
Karen Ward, a former UK Treasury adviser, said the traditional transmission mechanism by which rate rises tame price growth has been weakened by the enormous build-up of savings over the pandemic and the rush to lock-in low mortgage rates for long durations.
As a result, consumer spending is likely to remain more resilient and inflation more persistent than the BoE expects because “the household sector has become far less sensitive to interest rates than before,” Ward, now chief market strategist for Europe at JPMorgan Asset Management, said in an interview.
Ward sounded the alarm in the same week former central bankers Adam Posen, Charles Goodhart and Kristin Forbes all said the BoE will need to keep raising borrowing costs despite the economy unexpectedly contracting in March.
All told lawmakers that surging inflation meant the BoE would end up boosting its benchmark to at least 3%, with Goodhart saying it may need to go as far as 5% - a level last seen in 2008. That compares to the current rate of 1% and market bets that the top will be 2.5%.
By contrast, former government adviser Rupert Harrison, now at BlackRock Inc, said on Thursday that Governor Andrew Bailey and colleagues should pause their rate-hiking campaign and advised Chancellor of the Exchequer Rishi Sunak to provide more support to households on low incomes and consider cutting the sales tax temporarily.
Bloomberg Economics also expects the BoE to suspend tightening in June after four back-to-back hikes.
Still, households have three times as much in deposit savings than mortgages on floating interest rates, suggesting that higher rates create more spending power through the savings channel than they remove in higher debt-servicing costs.
The imbalance has not been as stark in the 15 years that the BoE has been collecting granular mortgage data. In a paper in February, the central bank admitted that the shift meant “the impact on net incomes of a rise in Bank Rate may be somewhat smaller than before the financial crisis.”
In an interview with Bloomberg News this week, BoE Deputy Governor for Markets Dave Ramsden said monetary policy “is still fit for purpose, but it may take a bit more time.” He added that commercial banks were more likely to pass rate rises on to mortgages than deposits.
Household balance sheets have been transformed in the past decade. Lockdowns during the pandemic led to a build-up of around £200bn of excess savings, none of which has been spent. At the same time, there has been dramatic change in home ownership.
Just 30% of households now have a mortgage. Four in five home loans are on fixed terms and half have tied in for five years. As a result, rate rises immediately impact fewer than 2mn households, just 6% of the UK total. In 2007, 16% would have been affected.
The BoE’s February analysis showed it will take almost three years for a rate rise today to have the same overnight impact on households as in 2007.
“There was already a question about whether spending would prove more resilient as people dipped into their lockdown savings,” Ward said.
“If people are earning more interest on those savings, it will only create a greater propensity to spend. That suggests there will be more resilience in demand and rates will have to go higher than thought and stay there. That could be 3%.”
“This deep-seated pessimism that the economy can’t cope with rates at 2.5% is wrong.” The BoE believes less direct mechanisms than savings and mortgages, such as exchange rates, will continue to prove effective. However, sterling has fallen against a trade-weighted basket of currencies this year, making imports more expensive.
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