An eventual rise in interest rates could prove a tougher environment for retail banks and consumer-focused businesses.
Many of you will think that it may be odd to contemplate the consequences of interest rates rising when all we hear points towards further procrastination by Central Banks, with some going even further and dipping their toes into the unorthodox water of negative interest rates.
However, barring significant external shocks or continued sharp market volatility, rates could start rising in a number of countries, including the UK, this time next year. The rise is likely to be very gradual, but most businesses underestimate the pain even a subdued increase could inflict.
Higher interest rates will be a boon to retail banks on the income side, but consequences on the credit side have potentially been overlooked. The latest Bank of England NMG Consulting survey1 shows that 31% of UK mortgage holders would need to take action, such as cut spending, work longer hours, or request a change to their mortgage, if interest rates rose by two percentage points and their income remained unchanged.
The same survey also reports that half of all borrowers surveyed, which included both mortgage holders and those who only have unsecured debt such as credit cards, would cut spending in response to a two percentage point rise in rates.
Rising income would help mitigate some of the impacts from higher interest rates, but gross household income has been largely anaemic, rising by less than 3% on average each year over the past decade, which would not be sufficient to avert a shift in borrowers’ behaviour.
The impact will not be equally felt: the proportion of mortgage holders that are highly geared is double in London and the South East compared to Scotland and Yorkshire. Among income groups, it is the low to middle income households in particular that are most highly geared in the UK, according to modelling by the Resolution Foundation2, the income groups with least alternative resources to call upon when the cost of credit rises. A study3 by the Federal Reserve Bank of San Francisco also found that the highest income households may better anticipate future changes in monetary policy than households in the lowest income quartile so they are more likely to be prepared.
Bear in mind that this time is different. Nearly nine years of no interest rates rise in the UK have seen a whole new generation of borrowers enter the market who have never experienced a rate increase, and many who have never had to make any financial decisions under a different base rate than the current zero lower bound. This group represents about 20% of all mortgage holders in the UK, not an insignificant bunch.
It is much more difficult to predict how this group will behave after the prolonged honeymoon of record low interest rates. Faced with a dearth of historical data that can be used in typical models, behavioural economics may shed some light. Studies4 by the Bank of Canada and Simon Fraser University point at a significant element of backward-looking when people form expectations for future inflation and interest rates. A long-lasting summer of record low interest rates is likely to dent people’s expectation for the future, especially if they have never previously experienced a rise.
The implications are numerous across different industries: while retail banks are longing for interest rates to start showing some guts, the costs in terms of bad loans are probably underestimated, especially for those exposed to the more vulnerable groups of borrowers.
However, the impact is likely to be felt much further. A decade of low interest rates served to lift consumer spending. Now rising interest rates are likely to see consumers cutting back on discretionary spend. Non-essential consumer goods, pubs and restaurants, gyms and sports clubs, and other entertainment could all be affected.
Those businesses that are targeting the lower income groups may suffer disproportionally, although they will also benefit from trading down of more premium products, as the middle class scrambles to adjust to the new world of higher interest rates.