Sunday, May 09, 2004
A long way from meltdown
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

On a scale of predictability, Thursday’s decision by the Bank of England to raise the base rate from 4% to 4.25% probably ranked nine out of ten.

People may be unaware of the extent to which Bank independence, combined with new technology, has created an industry. Immediately the monetary policy committee (MPC) announces its decision at noon, there is a rush of e-mails into my inbox.

For a while, one business organisation tried to pre-empt this rush by issuing an all-purpose release ahead of the announcement to cover a cut in rates (“We are pleased the Bank has responded to our concerns”), a rise (“We are not happy”) or no change (“Probably the right decision in the circumstances”).

The prize for the most inappropriate response to the latest hike goes to Kevin Hawkins, director-general of the British Retail Consortium, who said there was “no justification” for it. Retail sales are up by a booming 6.4% on a year ago.

The too-clever-by-half award goes to Oliver Letwin, the shadow chancellor, who said the rise should help to “counter Gordon Brown’s damaging policies”. Surely, if that is where you are coming from, the line should be that rates have gone up because of those damaging policies.

Leaving those aside, it is surprising how much nonsense is generated by a small, predictable, change in interest rates. Let me deal with some of it:

The Bank should have raised rates by half a point to shock borrowers

No it shouldn’t. In seven years of independence, the Bank has never increased rates other than by a quarter of a point, and that has served it well. The process of holding monthly meetings is designed to avoid big changes in rates (and in this context half a point means big). To have increased by more would imply that the economy had been hit by a sudden inflation shock.

By delaying the hike from April to May it took unnecessary risks with inflation

No it didn’t. The delay gave the MPC a chance to run through its new forecast. It also maintained its gradual approach to raising rates. Nobody can seriously argue that a one-month delay has any significant impact on future inflation prospects.

The Bank won’t say, but it is really targeting house prices

No it isn’t. As it made clear in its statement, house prices influenced its decisions only by contributing to consumer spending, and thereby the overall pace of economic growth. During the past seven years the MPC has raised rates when house-price inflation has been subdued and cut them when it has been accelerating. There has been no sustained correlation between the two.

Interest rates would be rising much more sharply if not for the switch in the inflation target

Again, not so. I am as big a critic of the switch in the target as the next man. But the Bank would have an apparent problem even with no switch. On the old measure (retail prices excluding mortgage interest payments), inflation, at 2.1%, is below its 2.5% target. As with the new measure, the Bank would have had to raise rates in anticipation of higher inflation to come.

This rate rise will tip heavily indebted consumers over the edge

The National Consumer Council says: “4.25% is the writing on the wall for the UK’s biggest ever credit binge”. This is what I want to concentrate on for the rest of this article.

It is easy to generate alarm on this subject. Let me start with a few facts. While unsecured debt (credit cards and the rest) continues to rise, it is doing so at a slower pace. In 1997, when the lack of a decisive feelgood factor helped to propel Labour to office, unsecured debt was rising at 17% a year. Today the annual growth rate is 12%. That is still too strong for some, but it does not suggest a sudden lurch into irresponsibility — the opposite, in fact.

The action, instead, has been in mortgage lending, which has undeniably accelerated. In 1997 it was rising by 5% a year. Now it is more than 15%. Most of the rise in household indebtedness comes down to an increase in mortgage debt from just over 70% of annual household post-tax income to nearly 100%.

The question is whether the rate rises in prospect are going to affect household finances so badly as to tip people into mortgage arrears, repossessions, and the whole miserable paraphernalia of the early 1990s.

Economists at Barclays Capital, in a recent exercise, Household Debt: Can We Really Afford This? looked at households’ sensitivity to rising interest rates by assessing the effect on “free income” — the money left over after tax and essentials such as food and fuel bills.

Their results were interesting. A rise in base rate from last year’s low of 3.5% to 5% — a reasonable guess for the rate peak — would take only 4.7% of a typical household’s free income. That compares with 11.1% when rates doubled from 7.5% to 15% in the late 1980s. In the present context, if you do the sums, it would take a rise in rates to 7%, in other words 11 more hikes from the Bank, to replicate the household “pain” of the late 1980s and early 1990s. We are a long way from that.

These figures deserve a bit of explanation. Most people will remember the rate rises of 1988-90 as taking rather more of their free income than 11%. But this is an average, spread over households with large and small mortgages, as it would be now. And 11%, which has to be directed into mortgage payments and away from other uses, represents a big hit to consumer spending.

But the real message, for both debt and the housing market, is that monetary policy operates in other ways beyond squeezing household budgets. Sharply rising unemployment is the ingredient that can turn a squeeze into recession and a housing-market crash.

That was true then, and it is true now. A rise in rates to 7% would have a big impact on companies, leading to widespread layoffs and replicating the rise in unemployment that was an essential feature of the last time boom turned to bust.

But the Bank, unless confronted with a new and unexpected inflation threat, will have no need to raise rates anything like that high. Oil, despite its rise, does not represent such a threat. A rise in the base rate to 5% will slow consumer spending, the housing market and the debt build-up. But it won’t bring any of these crashing down to earth.

PS: Readers will know I am always on the lookout for an all-purpose economic indicator, one that gives reliable signals of the economy’s strength or weakness come what may. My skip index (the number of builders’ skips in my street) has sadly gone wrong. The Easter drop in the skip count was no aberration. It is still suggesting the economy should be in recession when in fact it is growing strongly.

Other previously reliable measures have also gone awry recently. Kew Associates, in conjunction with Computer Weekly, has tracked IT spending for years and found it is almost perfectly aligned with gross domestic product, as well as other economic variables such as profitability, productivity and investment. Not lately, though. GDP growth has accelerated but IT spending has yet to pick up significantly.

So what to do? The Office for National Statistics produces an impressive array of data, but even some of its numbers are puzzling. Last week, together with the Transport Department, it stated that road traffic in the first quarter was up 2% on a year earlier, which is consistent with a growing economy, but goods-vehicle traffic was down 1%, which is not.

So the search is on again. I know that plenty of people have their own reliable “informal” economic indicators. It is time to share them with a wider public, through this column. This is no time to be bashful.

From The Sunday Times, May 9 2004

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