PENSIONSANDSAVINGS.COM

4  September 2013

• Bank of England should take off its blinkers and look at the economic evidence
• Low rates are distorting economy – causing borrowers and savers to take too much risk
• MPC should consider a small rise in rates now

As the Bank of England Monetary Policy Committee meets, I urge its members to look carefully at the evidence showing a stronger UK economy and start the process of increasing interest rates to more sustainable levels.  Ultra low interest rates are distorting the economy now, driving borrowers and savers to take on too much risk.  This is what caused the crisis in the first place, when financial markets misunderstood or mis-priced risk and encouraged irresponsible borrowing or lending.

Forecasts of economic weakness are out of line with the evidence: The Bank of England seems to believe – as do many of those calling for ongoing monetary easing – that the UK economy is still weak, that recovery has not yet arrived or that growth is not yet strong ‘enough’.

Where is the weakness?:  Looking at the economy without blinkers, it is hard to see why rates are at the emergency levels of 2009.  Consumer spending is strong, house prices are rising fast, manufacturing and the Purchasing Managers Index have increased sharply, construction is picking up, exports have improved and around a million new jobs have been created.

Enticing people into loans at artificial rates is repeating the mistakes that led to the crisis:  Bank of England policy seems to be focussing on helping the housing market to keep house prices and other asset prices rising.  But such policies were a major cause of the financial crisis.  Until 2008, house prices were boosted by irresponsible lending in the form of  ‘Self-cert’, interest-only and 125% mortgages, which helped borrowers pretend they could afford large loans. Everyone believed these loans were not too risky because house prices were rising sharply, the same seems to be happening again.  This time, borrowers are being lured in with record low mortgage rates instead, but the principle of rising house prices validating the borrowing once again underpins policy.

 

MORTGAGE RATES HAVE FALLEN

Date	2-year fixed rate Mortgage 75% LTV %	5-year fixed Rate Mortgage %	Tracker Mortgage %	Standard Variable Rate Mortgage %
Mar 2008	5.80	5.70	6.04	7.24
Mar 2009	3.98	4.95	4.01	4.06
Mar 2010	3.92	5.50	3.76	4.04
Mar 2011	3.68	5.10	3.47	4.07
Mar 2012	3.44	4.19	3.57	4.10
Mar 2013	2.90	3.63	3.56	4.34
July 2013	2.60	3.38	3.39	4.33
Interest rate change	-3.2%	-2.32%	-2.65%	-2.91%

~Source:  Bank of England Table G1.3

 

Low rates are unhealthy for the economy as they mislead borrowers by subsidising loans: Funding for Lending has driven mortgage rates down for now, but these are 25-year loans which may only carry low rates for a short time.  So keeping rates at such low levels for too long is misleading borrowers, enticing them to take out more loans than they can really afford and is ultimately unhealthy for the economy. The Bank of England should be concerned now about what will happen when rates rise again and buyers need to find far more money to service their debt.

Forcing savers to take on too much risk:   A further economic distortion of maintaining rates so low for so long is that savers are being forced to take on too much risk.  Rather than providing cash savings for banks to recycle to riskier lending – as would be the normal function of the banking system – savers are being forced to turn to riskier activities themselves in order to stop the value of their savings eroding.  They are being enticed into peer to peer lending or high yield bonds and equities if they want to keep up with inflation. These are loans that the banks are unwilling to make because they cannot afford to absorb losses, yet the risks are now being passed on to savers who may be even less able to absorb the loss.  This exposes the economy to extra risks, because savers need their money for their future financial security, but the money may not be there if these risky investments let them down.

Rates should rise slowly to avoid sharper rises later:  House prices are already booming in many areas, and will be further boosted by the Help To Buy scheme that will expose taxpayers to large losses if mortgage holders default on their loans in the next few years.  So I strongly believe the MPC should start gently easing interest rates up now, giving people a better idea of what they can really afford, rather than the illusion of affordability created by current artificially low rates.  Relying on borrowing to generate growth is merely bringing forward growth from tomorrow to today.  When the debts have to be repaid, growth will be impacted.  Better to have a gentle rise in rates rather than a sharp increase later.

Low interest rates are distorting the economy and not feeding through outside housing:  The current low rate environment has not really fed through to most other types of borrowing.  Indeed, rates on loans other than mortgages are in many cases higher than they were before the crisis began.  Banks have also been imposing extra charges and tougher terms for loans, especially for small firms, so the low rates policy seems to be allowing lenders to make much larger profits, while distorting the housing market and denying savers a decent return.

 

OTHER BORROWING INTEREST RATES HAVE RISEN

Date	Credit Card          %	Overdraft Rate %
Mar 2008	14.75	17.57
Mar 2009	15.73	18.63
Mar 2010	16.53	18.96
Mar 2011	16.66	19.08
Mar 2012	17.31	19.52
Jun 2012	17.25	19.51
Dec 2012	17.33	19.65
Jan 2013	17.61	19.55
Mar 2013	17.69	19.55
Jun 2013	17.84	19.55
July 2013	17.89	19.55
Int. rate change	+3.14%	+2.0%

Source:  Bank of England Table G1.3

Forward Guidance has come too late – it lacks credibility as the economy picks up:  The Bank of England’s forward guidance is designed to encourage borrowers to believe rates will stay low, so they can keep on borrowing without worrying about higher repayments.  That might have been helpful a few years ago, but is too late to be credible now, as the economy is clearly picking up.  The Bank of England has suggested that rates will not rise before the unemployment rate falls below 7%, but the rationale for targeting the unemployment rate as a policy trigger is not clear, especially as unemployment tends to be a lagging economic indicator.  Indeed, as the Governor also says he will not allow a housing bubble to emerge and as housing market indicators keep strengthening, forward guidance is clearly inconsistent.  What will he do to curb house prices if unemployment remains above 7%?

Markets are telling us that rates will need to rise much sooner than 2016.  The longer rates stay so low, the more distorted the economy becomes.