How will the Bank of England’s rate hike affect borrowers?
For 25 years the Bank of England had the power to set interest rates independently of the British government. For most of this period, rates followed a long-term downward trajectory. Not anymore. In December, in the face of persistent inflation, it became the first major central bank in the wealthy world to start raising rates since the pandemic. On August 4, it recorded a rate hike of 0.5 percentage points, the largest since 1995, two years before its independence. Investors expect further tightening, with the bank’s base rate falling from its current level of 1.75% to an expected peak of around 3% in early 2023. If inflation remains stubbornly high, it will could still increase.
The bank is trying to walk a very fine line. She doesn’t want to stifle growth unnecessarily, but she tries to change behaviors. Higher rates make saving more attractive and borrowing more expensive, discouraging spending and hopefully lowering inflation. Putting pressure on those in debt is a painful but necessary part of this. But the speed at which pain is felt varies greatly.
The bank’s base rate is what it pays on deposits held with it by commercial banks. For businesses, this helps determine how much they pay to borrow from commercial banks and what rate they have to pay on new bonds. For households, this determines how much they pay on loans, including mortgages: commercial banks will not want to lend them less than they can earn from risk-free deposits from the central bank. And for the Treasury, it determines the rate it has to pay on new government bonds (roughly the average of the base rate investors expect over the life of the bond).
Start with businesses. From the onset of the pandemic to the end of 2021, the world’s major central banks kept interest rates floored and flooded the market with liquidity via quantitative easing (what). As central banks seize government bonds via what, thus raising their prices and depressing their yields, investors hungry for yield became more inclined to lend to riskier borrowers. Companies were happy to oblige, to refinance whatever debt they could at better rates. UK companies currently owe £450 billion ($550 billion) of sterling-denominated debt to the bond market, a quarter of which has been issued since the start of 2020. Include bonds issued in other currencies and these figures stand at £1.2 billion and 37%, respectively. (Non-financial businesses have borrowed £490bn from banks and other lenders, but this figure is for all currencies and hedges will be in place to protect many against rate hikes.)
Since corporate bonds almost always carry a fixed interest rate, changes in the bank’s base rate only affect the issuer when the bond matures and needs to be refinanced. The recent wave of issuance means this will only happen to a small proportion of borrowers over the next few years. Excluding banks, building societies and insurers (which issue bonds, but also earn interest on loans and other securities), only 1% of UK pound-denominated corporate bonds will mature this year. About 90% mature in 2025 or later, and about 60% in 2030 or later (see Chart 1) . Any new debt issued from now on will reflect the higher base rate. But for the existing stock of corporate bonds, the bank’s ability to quickly influence borrowing costs is very limited indeed.
For household borrowing, the biggest impact of the rate hike is on mortgages: Britons owe £1.6m of residential mortgage debt. (Consumer debt, including credit cards and car loans, is much smaller, at £200billion.) Again, much of this borrowing – 82% – is at fixed rates. But the terms of fixed rate agreements are much shorter than those of the corporate bond market. Real estate consultant Neal Hudson analyzed an annual survey of mortgage borrowing last conducted by the central bank in September 2021; it calculates that 85% of outstanding mortgages were either variable-rate or fixed-rate that expire before 2025 (some may have been remortgaged to longer-term rates since then).
Homeowners whose fixed rates expire soon are likely to remortgage higher rates. For those borrowing three-quarters of the value of their property, two-year fixed rates are now 1.5 percentage points higher than they were two years ago; five-year rates are 0.9 points higher than they were five years ago (see chart 2). Based on an average house price of £283,000 and a term of 25 years, the two-year rate hike translates to an increase in monthly repayments from £840 to £993, or around 18 %, and comes on top of steep increases in food and energy bills.
An even bigger impact, Hudson says, can be felt by low-income renters with buy-to-let landlords. The share of fixed-rate rental mortgages is lower than that of owner-occupiers, around 70%. As variable rate mortgages increase, the pain will be felt by homeowners and, if they are able to pass on the cost, perhaps by their tenants as well. First-time buyers, meanwhile, will find that higher rates limit how much they can afford to borrow, putting downward pressure on house prices.
But for the strongest and most immediate pressure on borrowers, look to the government’s own finances. Gross public debt increased by £314 billion in 2020 and by £178 billion in 2021; in the first quarter of this year it was £2.4 billion, roughly equivalent to gdp. Like businesses, the government borrows mainly at fixed rates. But its debt is different from corporate debt in two ways. First, about a quarter of it is rising in line with inflation, which hit 9.4% in June. Second, the net effect of the bank what was to dramatically reduce the time it takes for a higher base rate to trickle down to government interest costs.
This is because when the central bank buys a government bond, it actually swaps it from fixed rate debt to floating rate debt. The central bank must pay its base rate on the new deposit created to buy the bond; and since the profits or losses of the bank are ultimately those of the government, this is the new cost of servicing the debt. Currently, the Bank of England holds nearly two-fifths of public debt (see Chart 3), on which the effective interest cost increases immediately in line with the base rate. Although the weighted average maturity of UK government bonds is over 15 years, higher borrowing costs will affect half of its debt in just two years.
Households and businesses will all be affected by the continued rise in rates. But the Treasury will feel it more. But ultimately, it comes down to the same thing. A rising interest bill will drive up government borrowing without active spending cuts elsewhere. And higher borrowing could force the Bank of England to tighten monetary policy even further. Those who are spared the immediate pressure will always foot the bill in the end. ■