Impact of interest rate rise - When and how much is it going to hurt

Current market expectations suggest the Bank of England will begin hiking the Bank Rate in the summer of 2015. This notion is also supported by the shifting tone in communications from the Monetary Policy Committee (MPC) and recent comments from Mark Carney – Bank of England Governor. The Bank suggest a 25bp rise followed by a gradual and gentle path of increases – the second almost certainly before the end of the year.

However, the Committee remains deeply concerned with persistent weakness in wage growth – just 0.7% in September. Until a pick-up in productivity, followed by an increase in wages, a high degree of uncertainty surrounds the timing of the first rise. With inflation hitting a five year low in September – expectations of a rate rise has been pushed back further.

However, it’s not a case of if but when.

Transmission Mechanism
• When interest rates begin to rise, the mortgage interest burden will begin subtracting from households' disposable income growth.
• Paying credit cards and other debts will become more expensive.
• Pace of disposable income growth will dictate how quickly consumer spending will grow – since two thirds of the economy is made up of consumer spending and one third of consumer spending is retail – there will be a direct and immediate impact on the retail sector and the overall economy

Measuring the impact
• During the 2003 and 2006 hiking cycles, the Bank of England raised interest rates by 125bp over the period of around a year.
• In both cases this caused the mortgage interest burden to subtract around 1.5 points from disposable income growth.
• Given around 65% of mortgages are directly linked to Bank Rate, any rise is likely to be more powerful than at the time of the last hike when there were only around 38% of mortgages linked directly to Bank Rate.

Impact on consumer spending and retail
• The initial impact is likely to be felt through lower levels of consumer confidence as households begin to feel increasingly nervous about their exposure.
• Swathe of new home owners over the last five years who have never experienced rising mortgages.
• Sectors likely to be impacted first include furniture and flooring, home, mid-tier fashion, DIY and Gardening.

What about this time?
• We forecast that a 100bp rise in rates during 2015 will take around 2 percentage points from household disposable income growth.
• If households choose not to borrow more or save less, and consumer spending growth falls by exactly is amount then 1.2% will be shaved off of GDP growth.
• After the first rate rise, the anticipation of more rate hikes to come will likely influence the spending behaviour of households and businesses.

Further Downside Risks
The recovery has been supported by strong consumer spending which, given earnings growth remains weak, has been driven by households saving less and feeling-good factor of rising house prices has encouraged people increase their spending by more than their incomes. If the rise in rates pushes house price inflation to much lower levels (or even declining house prices) this is likely to reduce consumers’ willingness to spend. The combined impact (direct and indirect) may mean a subtracting in GDP growth by c.2 percentage points.

Sense will prevail
The Bank of England has just undergone the worst recession since the 1930s and in terms of policy, the focus is no longer solely on its inflation target. The MPC is likely to accept elevated levels of inflation in the economy if aggressive hikes begin to choke off recovery. In addition, the outlook for inflation remains benign which is favourable for a gentle and protracted rise in Bank Rate to more normal levels.

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