Interest rate swings and roundabouts

Tony Ward

July 31, 2017

Tony Ward is chief executive of Clayton Euro Risk

Back to another familiar topic: talk of an interest rate rise – although, as the smart money now suggests, not an imminent one.

The Bank of England’s Monetary Policy Committee (MPC) is due to meet this Thursday. It seems that the majority of economists and investors now expect the Bank to leave rates on hold. Speculation had mounted that an increase in base rate was on the cards after three members of the eight-strong MPC voted for a rise at its last meeting. However, since then GDP growth has slowed to 0.3% in the second quarter, according to the Office for National Statistics, and rising inflation, which had worried some rate setters, went into reverse, dipping from 2.9% to 2.6%. On top of that, Kristin Forbes, one of the MPC members in favour of a rate increase, has left the panel. “The odds now very strongly favour the Bank of England keeping interest rates at 0.25% after the August MPC meeting,” observed Howard Archer, EY Item Club. “The chance of an interest rate hike any time soon is currently dwindling.”

The time is nigh for a rate rise

Sensible decision, in my opinion. In June, I wrote that now was not the time to tinker with interest rates. I argued it would be foolhardy to raise rates against a weakening economy and both political and Brexit uncertainty. Thankfully, most economists now seem to agree. Christian Schulz at Citi said: “Even a small rate hike could have repercussions for the economy in its current fragile state. Until there is more clarity about the Brexit deal, the Bank of England will probably abstain from adding to that fragility by hiking rates. We expect the first step in November 2019.” Agreed.

And yet, just as I’m beginning to breath more easily about interest rates, other issues have started to trouble me. Some of these result from the consequences of pursing a long-term low interest rate policy.

The Bank of England sounded the alarm last week that consumer credit is booming with the outstanding volume of car loans, credit card balances and personal loans climbing 10% in the past year. This compares with a rise of just 1.5% in household income. Alex Brazier, the Bank’s director for financial stability, said that lenders risk slipping into a ‘spiral of complacency’ over mounting consumer debt.

Is the Bank being unduly alarmist? Quite possibly. Overall household debt has actually been cut since the financial crisis, although it remains high at 135% of household income. Also, the financial system is now on much safer ground with bank capital increasing threefold since the credit crisis. Mr Brazier may have a point, however, when he suggests that lenders are showing ‘classic signs’ of thinking risks have receded following a prolonged period of low losses on loans.

And that, of course, is promoted by a low interest rate environment. The problems can be perceived as partly a consequence of the policies pursued by the Bank. A long stretch of near-zero interest rates has squeezed lenders’ profit margins; this coupled with a deluge of post-crisis regulation that has made investment banking less profitable, has had the consequence of pushing the big banks to pursue profits in areas such as credit cards, car finance and personal loans.

“The fear is when you keep monetary policy loose, you get these hotspots,” said James McCann, Standard Life Investments. “It’s like a water bed, you lean down on one area and something pops up elsewhere. Banks will look to where they can make profits. It’s classic.”

And that’s the flipside of the interest-rate coin – the roundabout to this particularly tricky swing. I accept that low rates are necessary to encourage people to carry on spending – particularly in an economy so dependent on the consumer.

But low rates pose their own danger: they encourage the build-up of personal debt, which could pose a risk if the economy slows significantly – or if the rate rises too quickly and burdens borrowers with hefty interest charges. That personal debt can swiftly become a millstone around the economy’s neck – if you’ll forgive the abundance of metaphors.

It’s a conundrum, I accept. No wonder Mark Carney, Governor of the Bank of England, has ordered a detailed analysis of lenders’ underwriting. He has also brought forward the consumer credit portion of the Bank’s stress tests by two months, the results of which will now be revealed in September. So perhaps then we will know just how big a conundrum we have to deal with.

In the meantime, the debate amongst economists and investors as to whether to maintain or raise rates will continue. I wish I had more answers, but I can only restate my plea for a watch-and-wait approach.

It’s all swings and roundabouts. And whichever one you choose, you’re going to get very dizzy.

 

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