You might think higher interest rates hurt, but they're a sign of economic health

In the medium term the Bank of England wants a reasonably elevated level of interest rates because it will imply a healthily growing economy.

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The Independent Online

Aristotle was not a fan of interest rates. “Money was intended to be used in exchange, but not to increase at interest” the Greek philosopher taught his followers in 350BC. “Of all modes of getting wealth, this is the most unnatural.” We tend to take a more nuanced view today, but the father of Western philosophy nevertheless might have been at home in modern Britain.

Short-term interest rates set by the Bank of England have been negligible (just 0.5 per cent) for six full years now. Not much room for “unnatural” profit there. The Bank hasn’t put up its base rate since 2007. However, the feeling is growing that this is about to change. Currency traders, who make a living from betting on these things, think America’s central bank, the Federal Reserve, will put up its own main interest rates next month for the first time since the global financial crisis. The Bank of England is widely expected to follow next spring.

Many borrowers will have forgotten what it feels like for the Bank to mandate an economy-wide increase in the short-term cost of money. Anyone who first took out a mortgage in the last eight years will have no experience of the way an interest rate hike by the Bank ripples out through the borrowing market like a boulder dropped into the waters of a lake.

All borrowers are different, but let’s consider a fairly typical example. Imagine someone with a £200,000 mortgage, a 20-year repayment term, and a 2 per cent interest rate that varies with the Bank’s base rate. A 0.25 per cent increase in the base rate (which is the interval that the Bank generally tends to move in) would mean a monthly repayment of £1,012 turning into a repayment of £1,036 – an extra £24 a month. Probably not an excruciating burden for most people.

But what if the base rate carried on rising, hitting 2.5 per cent in a few years? That would mean the annual mortgage interest rate for this hypothetical borrower doubling from 2 per cent to 4 per cent. And that would push the monthly repayments to £1,212 per month – an extra £200. For many families, that could prove tricky to find.

A recent survey of household finances by the Bank of England suggested that if base rates rose from 0.5 per cent to 2.5 per cent, the proportion of mortgage borrowers judged to be vulnerable (defined as spending more than 40 per cent of their monthly gross income on debt repayments) would double from 4 per cent to about 8 per cent. However, if household incomes also rose 10 per cent, the proportion of vulnerable borrowers would only increase to 6 per cent.

And, of course, not everyone who owns their home is a borrower: the number of households who own a property outright (7.4 million) has now overtaken the number of mortgage borrowers (6.9 million). The Bank calculates that if interest rates rose by 2 percentage points, the total proportion of vulnerable households would increase from 1.3 per cent to just 1.8 per cent, again based on the assumption that wages increase by 10 per cent over that period. So provided average incomes increase over the coming years, modestly rising interest rates shouldn’t hammer Britain as a whole. Rising interest rates need not derail the recovery.

However, the Bank is rightly in no hurry to put rates up. And we should be pleased that it has ignored those in recent years who have been pressing for an increase in rates on the grounds that people with money in current accounts have been getting miserably low returns on their deposits.

The notion that the Bank has been deliberately keeping rates low in order to subsidise borrowers at the expense of savers has gained some traction, yet it is based on a misunderstanding of the objective of monetary policy. The Bank’s mandate is to keep inflation close to its 2 per cent target over the medium term. This facilitates overall GDP growth in the economy, so getting this balance right is to the ultimate benefit of both savers and borrowers. Their long-term interests are aligned.

The Bank is also keen to stress that when interest rates do rise they will not shoot into the stratosphere – and that households and businesses are not soon going to face punishing borrowing costs. This is appropriate. There is indeed a danger that putting up interest rates after such as long time could damage consumer and business confidence, even if the immediate increase in the debt-financing burden isn’t particularly severe.

 

Yet there’s a certain irony here in that in the medium term the Bank does want a reasonably elevated level of interest rates because it will imply a healthily growing economy which is generating strong wage growth and moderate consumer inflation.

Larry Summers, the distinguished American economist who narrowly missed out on being appointed the head of America’s central bank, has been offering a disturbing alternative hypothesis: interest rates in the Western world could be depressed for a very long time thanks to big headwinds to growth such as an ageing population, the plummeting price of capital investment goods and greater economic inequality. Under this view of the world, central banks will need to keep base rates down almost permanently in an attempt to stave off deflationary forces – and even those low rates may not be sufficient to achieve this.

There are reasons for believing that this “secular stagnation” theory is overly pessimistic. But interest rates in Japan are still on the floor a full quarter of a century after the country’s massive property bubble burst in the early 1990s, and partly because of the deep structural forces identified by Summers.

Aristotle, of course, would be pleased with zero interest rates forever. That’s a fate the rest of us should pray we avoid.

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