Households face a sharp fall in disposable income when the Bank of England raises interest rates that could derail the recovery if the pace of increases is quicker than anticipated, according to the Telegraph.
The analysis conducted by Scotiabank found a one percentage point rise in interest rates over a year would knock around two percentage points off headline UK growth.
The research – based on reaction to past increases – showed rate rises and higher mortgage repayments would hit consumer spending, subtracting around 1.2 percentage points from gross domestic product (GDP) growth. Alan Clarke, head of fixed income at Scotiabank, said rises would also affect sentiment. Many consumers have funded purchases over the past year by driving down their savings.
Mr Clarke said higher rates would reduce consumers’ willingness to increase spending by more than their incomes, subtracting a further 0.75 percentage points from UK GDP growth.
“The consensus of forecasters is expecting the economy to grow by almost 3pc this year,” he said. “The bottom line is that if rising interest rates do subtract close to 2pc from headline growth, then we might expect to see growth of closer to 1pc over the coming years.
“We should enjoy this year’s bumper growth while we can.”
Mr Clarke said Bank policymakers could “choke off the recovery” if they did not plan interest rate rises carefully. “Once it seems certain that the first rate hike is coming, several more will be expected,” he said. The anticipation of more rate rises to come will likely influence the spending behaviour of households and businesses.”
A sharper jump in interest rates, caused by capacity constraints that would push up labour costs and inflation, could also “wipe out” the recovery or even throw Britain back into recession, Mr Clarke said. Bank of England data suggest higher interest rates could affect consumers more than previous cycles because around 65pc of mortgages are now linked directly to Bank Rate, compared with 38pc before the financial crisis.
Mark Carney, the Governor of the Bank of England, has insisted that eventual rate rises will be gradual. “The Bank will not take risks with the recovery”, he said at the February Inflation Report.
While Mr Clarke said a scenario of rapid rate rises was “highly unlikely” because the Bank was much more likely to tolerate high inflation than raise rates and “choke off the recovery”, experts warned that if signs emerged that increased labour costs were pushing up prices, the Bank may not have a choice.
“The argument for tolerating higher inflation in the past is that it appeared to be caused by temporary factors,” said Andrew Sentance, senior economic adviser to PwC and a former Bank policymaker. “But if you’ve got inflation driven by the fact that tightening in the labour market is putting pressure on wages – it’s going to be hard to argue that that’s just a blip – the Bank would need to cool the economy down.”
While inflation, at 1.6pc, is at its lowest since 2009, recent surveys have shown that nominal wages are “on the cusp of a strong recovery”, according to Ian McCafferty, a Bank policymaker.
Mr Sentance has argued that gradual rate rises should begin now to avoid sharper rate rises later.
“The [Bank] has said that if it thought it was was going to knock the recovery on the head with interest rate rises, it wouldn’t raise them dramatically,” said Mr Sentence.
“But they could find themselves in an awkward position where there is a much more immediate inflation threat than you have now. That will put them behind the curve – then they may have no other choice than to raise rates sharply.”