Monetary Policy

Inflation: there will be no soft landing

With inflation expectations on a downward trajectory, the Bank of England – and the British public for that matter – are hoping for this cost of living crisis to subside. We should not, however, get our hopes up for a quick economic revival.

The Bank of England’s latest dose of kill-or-cure interest rate hikes will only begin to lower inflation later this year and at the start of the next as their effects trickle through the economy. While this may initially seem like a good thing, it is not. Today’s ’cost-of-living crisis’ is like a hydra. Once subdued it will only be accompanied by an equally malevolent ‘cost of credit crisis’, courtesy of real interest rates carrying over into the real economy.

One look at the Bank’s Financial Stability Report shows how, for households, the struggle will continue throughout the next few years. The crucial takeaway is that mortgage payments for one million households will jump by £500 by the end of 2026. This fact should raise alarm bells; rising mortgage payments and an increase in the number people struggling to meet them was a warning sign of the impending financial crash throughout 2008.

Yet, history is unlikely to repeat itself for two reasons. First, the proportion of households with high mortgage COLA-DSRs – an awfully technocratic term which just measures how living costs affect people’s ability to service debts – is expected to increase throughout 2023 but will still stay below its 2007 peak. Second, because of strong capital and profitability, UK banks can offer forbearance and limit the increase in repayments faced by borrowers by varying loan terms such as length. We can already see some households taking up the option to borrow over longer terms, as they attempt to offset the impact of higher mortgage rates. On top of this, the Bank’s stress test scenario shows that the UK financial sector is safe even if unemployment reaches 8.5% making financial collapse unlikely.

While unlikely, such a scenario is not impossible. Inflation has only just begun decreasing and better-than-expected wage growth is pointing towards additional rate rises from the Bank of England. Should mortgage rates rise to three percentage points higher relative to current expectations, the number of households suffering from high COLA-DSRs will reach financial crisis levels. Moreover, with UK homeowners being forced to refinance every two to five years – as opposed to US homeowners who have 30-year fixed-rate mortgages – the cost of credit crisis will be felt more acutely in Britain.

The ‘word’ crisis is used quite liberally here, it makes us think of an event but the key to understanding the current economic environment is that this crisis may be a prolonged period of slow decline and suffering.

Ultimately, rising interest rates will put pressure on those on the lower end of the income distribution. Household incomes will be stretched and many will be forced to contribute larger shares of their earnings towards debt repayments during the economic recovery. This will make many consumers poorer but what’s more important are the implications that this has on the structure of our economy.

With mortgage repossessions rising because of tenants being unable to meet rising rent payments, we will likely see the housing market becoming dominated by larger banks that can afford to offer forbearance. For financial markets, this may create two outcomes: increasing concentration ratios and better-fixed rate terms akin to those of the US.

Looking into the real economy, the deterioration of disposable incomes will inevitably lead to diminished savings and with this, the UK will be increasingly prone to economic shocks as households – especially the poorest amongst us – will have an even smaller safety net.

The corporate sector is likely to also suffer. Bond finance makes up a large portion of corporate total debt and while these bonds are usually fixed-interest, it does mean that corporate issuers will face higher costs when they need to refinance. However, for small to medium-sized firms, the most common form of debt is bank credit. While figures do suggest that corporate indebtedness is low, it is also not equally spread and so the insolvency rate for large to medium-sized firms is beginning to increase slightly.

This is something which macroeconomists should pay strong attention to. Mountains of debt underscored by economic turbulence have been no stranger to causing past crises – especially the GFC. Unfortunately, the Bank of England does not report the distributional data to properly identify these risks to those on lower incomes. As such, while the aggregate picture the Bank paints is quite sound, the reality is one where low-income households will suffer.

Thus, there is an important lesson is learned. The decline in inflation that we all so hope for will not be smooth sailing. The cost of credit crisis that will mark the end of this year and the turn of the next may be a quiet one. Nevertheless, we must pay attention to it, as it risks leaving the British economy in an increasingly precarious position.

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