Sunday, March 06, 2011
Would the squeezed middle cope with higher rates?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular piece is available to subscribers on This is an excerpt.

Three members of the Bank of England’s monetary policy committee (MPC) and now six members of the Institute of Economic Affairs’ shadow MPC favour an immediate rate hike. Eventually they will get it, though it would be a surprise if it happens this week. The ECB, for its part, looks ready to hike in April, so a May hike from the Bank would not be out on a limb.

So I don’t want to dwell on this week’s MPC decision. I’ll repeat, because some people have great difficulty understanding this very simple point, the Bank was not powerless to prevent inflation rising above the 2% target. This despite the main upward influences on the price level being international and fiscal (the Vat rise).

The Bank had the choice of offsetting these pressures by imposing downward pressures on other prices by hiking interest rates. It decided not to, sensibly, because the pain would have been too great.

As Charlie Bean, deputy governor, put it last week: “When there are adverse cost shocks: inflation can be stabilised, but only at the cost of volatility in output. Or, as Mervyn King put it more directly recently, “only a much deeper recession” would have stopped inflation overshooting.

The powerlessness argument is economic illiteracy but that does not mean there is no good case against rate hikes.

The strongest of these focuses on the household sector, the “squeezed middle” beloved of the politicians. If I were very poor, or for that matter very rich, I would take umbrage at my squeeze not being acknowledged. But like “hard-working families”, or for that matter the Big Society, politicians cannot resist these labels.

The squeeze is real. Though pay rises are accelerating - Incomes Data Services says median pay awards in the three months to January were 2.8%, up from 2.2% - they remain well below inflation.

People face an array of tax hikes and benefit cuts next month, some of which will come to them out of the blue. They include the 1% rise in employee National Insurance, equivalent to an income tax hike, bequeathed by Alistair Darling; a drop in the 40% higher rate threshold from £43,875 to £42,475; a freeze on child benefit and cuts in child tax credits and childcare support.

Alcohol duties will be increased by 2% more than inflation, while the new 1% fuel duty escalator is also due to kick in (though will surely be scrapped by George Osborne). Benefits and public sector pensions will be raised in line with the consumer prices index rather than retail prices index. Benefits are being squeezed in many other areas and, at the other end of the scale, the inheritance tax threshold is being frozen and stamp duty up to 5% on £1m-plus houses.

The impact of other public spending cuts is harder to quantify but will be real, particularly for households and regions most dependent on the public sector.

So what justification is there for adding to the queeze from rising prices and higher taxes by raising interest rates? Would not that tip many families over the edge, risking a dive back into recession and, by triggering a wave of repossessions and bad debts, create new problems for the banks?

The first thing to say is that most people in Britain do not have a mortgage, or any significant debt at all. There are just over 26m households in the UK, and 10m mortgages, less than 40% of the total.

A rise in interest rates benefits savers while hurting mortgage borrowers - and as every chancellor will attest from their mailbags, there are more savers than borrowers in the economy as a whole.

This is not to say the economic impact of higher rates is neutral. Typically borrowers spend a higher proportion of income than savers. While savers have absorbed their loss of income from a record low Bank rate , without apparently suffering huge distress - in some cases taking Bean’s advice and eating into capital - many borrowers would have found themselves in trouble had the Bank not cut rates so aggressively.

But how much distress would borrowing households face now? The Financial Services Authority, enjoying its swansong period, last week published its Retail Conduct Risk Outlook for 2011.

While there had been some reduction in debt levels, it warned that “many households continue to carry high levels of debt, which may leave them vulnerable to future income shocks - either as a result of unemployment, or rising interest payments”.

The Bank’s aggressive cuts in interest rates created a £20 billion transfer from savers to borrowers, according to FSA calculations, with the lion’s share of that transfer going to those who borrowed heavily - 90% or more of property value - and were lucky enough to take out a Bank rate tracker mortgage before the crisis.

Some of them will be highly vulnerable to higher rates but those who could should have taken action to protect themselves against the inevitable post-crisis rise in rates. There is a moral as well as an economic question about whether savers should permanently suffer to make life comfortable for big borrowers.

The FSA warned that continued very low rates could also be risky. One risk is that even the highly indebted will be tempted to take on more debt. Another is that savers, in the search for return, will be drawn into risky investments.

There are two other points to make. One is that the rise in Bank rate, when it comes, will be a lot gentler than the fall. A quarter-point every three months is what I would expect. I would question how many households cannot cope with that.

Second, I would expect rate hikes to have consequences for bank margins. Households and businesses pay well above 0.5% Bank rate. Credit card rates are close to 20%. There will be scope for these margins to narrow, and they should do so.

For households, and the wider economy, things would be a lot more comfortable if any rate hikes could be delayed until 2012, when, if the Bank is right in its inflation projections, the squeeze on real incomes ease. I doubt, however, if the Bank will have the luxury of waiting that long.