Over the past year, interest rates have been rising rapidly around the world. The post-COVID economic recovery and Russia’s invasion of Ukraine caused inflation to reach 10% or more in many countries. Central banks in the US, UK and Europe have fought back by raising interest rates in an attempt to cool the economy and return inflation to their 2% targets.
This has already hit mortgage holders whose repayments are linked to central bank rates. In the UK, the Bank of England raised its rate in June by a further 0.5 percentage points to 5%, the highest level since 2008. Households coming to the end of fixed-rate mortgage deals next year now face an average increase in annual payments of £2,900, according to research by the Resolution Foundation.
Worse is yet to come. Financial markets are forecasting interest rates of 6% by the end of the year.
The need for such sharp rate rises to tackle inflation can be partly traced to the Bank of England having been slow to act. But the UK government has also made missteps over the past year by not using its fiscal policy (tax and spending) to help the Bank of England’s monetary policy (interest rate changes) defeat inflation. Central banks are expected to continue to raise rates while, in the UK, the government is simply looking on.
UK chancellor Jeremy Hunt has met with lenders and announced measures to help struggling homeowners. But he has been clear that the government will not intervene by stopping rate hikes or directly subsidising homeowners’ mortgages.
Can rate rises slay inflation?
Hunt has said the Bank of England’s rate rises have his “full support” as “one of the most effective methods of bringing inflation down”.
It is true that rate rises can cool inflation by cooling the economy. By raising the repayment costs of mortgages and other sorts of loan, consumers, business and even the government are left with less money to spend.
The problem is that if rates rise too fast, the banking system can collapse. In my latest book Calming the Storms: the Carry Trade, the Banking School and British Financial Crises Since 1825, I discuss how all major financial crises in Britain over the past 200 years were triggered by excessively rapid rises in interest rates.
More recent near-misses include the market panic triggered by ex-prime minister Liz Truss’s ill-conceived mini-budget last autumn. Its unfunded tax cuts and proposed borrowing splurge caused a rapid rise in interest rates and brought Britain within 24 hours of a full-scale financial crisis. Thankfully, Truss u-turned on her policies.
Likewise, the collapse of Silicon Valley Bank and the resulting US banking crisis last March was triggered by rising interest rates.
How to avoid financial instability
International economic institutions have also begun to wake up to the risks of rapid rate rises. The Bank for International Settlements – often referred to as central bankers’ central bank – has recently pushed for the use of tax rises and spending cuts as additional means of reducing inflation.
“It would reduce the need for monetary policy to keep interest rates higher for longer, thereby reducing the risk of financial instability,” stated its 2023 report on the global economy, published June 25.
Likewise, the deputy head of the International Monetary Fund told the Financial Times on June 26 that central banks had to face the “uncomfortable truth” that they might have to tolerate periods of above-2% inflation to avoid their interest rate rises triggering further financial instability. Bank of England governor Andrew Bailey has also recently indicated that inflation and interest rates may remain high for longer than expected.
I outlined the case for the UK to tackle inflation using fiscal policy – that is, changes to tax and spending rather than interest rates alone – in a policy paper delivered to HM Treasury last autumn, before Truss’s mini-budget created market turmoil. I pointed out that rapid rises in interest rates to deal with inflation would cause a financial crisis in the shadow banking sector, which includes financial firms that don’t come under the stricter regulations of the mainstream banking sector.
Changes in fiscal policy – such as cuts to VAT, which would directly reduce prices – could help return inflation back to the Bank of England’s target without destabilising the banking sector. These could be paid for by axing tax reliefs enjoyed mainly by the wealthy, such as the discount for declaring income as capital gains instead of as income.
Such fiscal measures could re-anchor businesses’ and consumers’ expectations for future price rises at 2%. Rather than trying to cool the economy by pushing up the repayment costs of a relatively small number of mortgage holders, raising taxes would have instead shared the burden out more equally or equitably.
Fiscal policy to the rescue?
Unfortunately, this advice was ignored in Truss’s mini-budget. As a Conservative, she has a strong political aversion to raising direct taxes that might impact wealthy voters.
The appointment of Hunt as chancellor and then Rishi Sunak as prime minister following the ill-fated mini-budget resulted in most of its measures being reversed. This calmed markets, and interest rates fell back. Rather than considering more tax increases in this year’s budget, Hunt said inflation would fall back over the course of this year, thanks to falling energy and commodity prices.
But far from falling, core inflation, which excludes volatile food and energy costs, has risen from 5.1% to 7.1% between January and June this year.
Similarly, annual wage growth has risen to 7.2%, triggering a price-wage spiral. This happens when wage rises push up prices, which then pushes wages up, and so on. If fiscal and tax policy had been used to reinforce the 2% target last year, a wage-price spiral might have been avoided.
Sunak has promised to halve inflation from its peak by the end of the year, hoping this will give him enough support to win the next general election. But without more determined action by the government, the odds of Sunak’s gamble working out for him – and for UK mortgage borrowers – look ever longer.