This morning’s UK inflation data can be described in just two words: truly horrible. With headline inflation stuck at 8.7 per cent and core underlying inflation rising from 6.8 per cent to 7.1 per cent, the Bank of England is facing a huge problem. Most thought the Bank’s key policy rate would rise by a quarter of one per cent tomorrow. Some are now thinking that it will have to move by half of one per cent.
Anyone with a mortgage will be feeling nervous. Interest rates are a remarkably blunt instrument. Yes, they’ll eventually do the job of bringing inflation to heel. Along the way, however, there’s likely to be considerable collateral damage. Homeowners with big mortgages are in the firing line.
I know how it feels. As a new homeowner at the beginning of the Nineties, I became only too aware of the damage caused by high interest rates. We bought our flat near the very peak of the market. Between 1989 and the trough six years later, house prices across the country fell in real terms (adjusted for inflation) by a whopping 35 per cent. We had, in effect, borrowed against what turned out to be a rapidly depreciating asset.
Like many others, I began to fear being trapped in so-called negative equity, where our mortgage would be worth more than our fast-depreciating property. I became economically cautious, a rational response at the individual level but, in aggregate, an approach that was only likely to leave the nation in a serious economic funk.
House prices today are down from their recent peak by around 12 or 13 per cent in real terms. It’s a big drop but, as Bachman-Turner Overdrive put it, “You Ain’t Seen Nothin’ Yet”. Inflation is a sticky adversary. That means higher interest rates for even longer.
Worse, many have yet to see the full impact of the Bank’s earlier monetary tightening. A large number of fixed-term mortgages (such mortgages are far more plentiful than they were when I first climbed on the housing ladder) will “reset” in the coming months, with some borrowers experiencing a rise in borrowing costs from less than one per cent to, say, five or six per cent. That’s likely to trigger a wave of further selling, renewed downward pressure on house prices and, dare I say it, a lot more talk about recession.
How have we ended up in this situation? Three reasons stand out.
First, for too long, the Bank of England gave the impression that the main risk to price stability was deflation, not inflation, implying that interest rates would stay at very low levels for ever more. This was a serious misreading of history. Inflation may at times be dormant, but no one has yet killed it off altogether. The ridiculously low interest rates seen in the aftermath of the 2008 global financial crisis should always have been regarded as the exception, not the norm: yet house prices soared based on the idea that easy money was here to stay.
Second, when the monetary brakes are applied, the housing market is always vulnerable. True, fixed rate mortgages provide an extra degree of certainty compared with when I was borrowing in the early Nineties at more volatile overnight interest rates. Because, however, many mortgages are taken out for around 25 years while most fixed-rate deals last anywhere between one and five years, these deals are, in truth, hybrids: neither fully floating nor fully fixed. As such, higher short-term interest rates will eventually bite — and they will, in the coming months.
Third, over the very long run, house prices generally do rise. The tax treatment is very favourable (no capital gains tax has to be paid on a person’s primary home). Thanks in part to planning red tape, housing supply has not kept up with demand. Housing, therefore, is an asset which, for the most part, is worth owning. Last year, however, the ratio of house prices to earnings (or wages) rose to levels last seen in the late-19th century. In other words, housing had become unusually expensive relative to otherwise-favourable long-run trends. Sometimes, these can be totally swamped by short-run bubbles.
The Bank of England absolutely should be tackling inflation but, as today’s numbers show, it has so far not done enough. Defeating inflation is never pain-free, particularly when the initial response was far too slow. Many homeowners are set to be hit very hard.
Stephen King (@kingeconomist) is HSBC’s Senior Economic Adviser and author of We Need to Talk About Inflation (Yale)
