Author: Dean Garratt

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Inflation, interest rates and mortgage repayments

This is the first of three blogs looking at inflation, at its effect on household budgets and at monetary policy to bring inflation back to the target rate. This first one takes an overview.

The housing and mortgage markets are vitally important to the financial well-being of many households. We have seen this vividly in recent times through the impact of rising inflation rates on interest rates and, in turn, on mortgage repayments. Some people on variable rate mortgages, or whose fixed rate deals are coming to the end of their term, have struggled to pay the new higher rates. In this blog we explore the reasons behind these events and the extent to which the financial well-being of UK households has been affected.

Chart 1 shows the path of inflation in the UK since 1997 when the Bank of England’s Monetary Policy Committee (MPC) was first charged with meeting an inflation rate target (click here for a PowerPoint). It captures the impact of the inflation shock that began to emerge in 2021 and saw the CPI inflation rate peak at 11.1 per cent in October 2022 – considerably above the Bank’s 2 per cent target.

Despite easing somewhat, the CPI inflation rate is showing signs of persistence – meaning that it is taking time for it to return to target. One way of understanding this persistence is to look at a measure of inflation known as core inflation. This inflation rate measure excludes energy, food, alcoholic beverages and tobacco prices, all of which are notoriously volatile. Core inflation thus captures underlying inflationary pressures.

To address the inflationary pressures, the Bank of England began raising Bank Rate in December 2021 from a low of just 0.1 per cent. By June 2023 the Bank Rate had risen to 5 per cent with the prospect of further hikes. As the Bank Rate rises, the cost of borrowing from the Bank of England by commercial banks rises too. Therefore increases in the Bank Rate ripple through to other interest rates. However, the passthrough effect can be uneven affecting spreads between Bank Rate and other interest rates.

The increase in the Bank Rate is reflected in the increases in mortgage rates shown in Chart 2 (click here for a PowerPoint). As we have seen, this affects most immediately those with variable rate mortgages, and then those with fixed-rate mortgages as they come up for renewal. Analysis from the Resolution Foundation (2023) estimates that 4.2 million households saw their mortgage rates change between December 2021 and June 2023 – the equivalent of 56 per cent of mortgaged households.

The persistence of inflation means that mortgage rates may not have yet peaked and are likely to stay higher for longer than originally thought. With fixes normally between two to five years, the problem of higher rates for those renewing will continue. The Resolution Foundation projects that by the end of 2026, almost all households with a mortgage would have moved to a higher rate since December 2021. At this point, the typical annual repayment cost for mortgaged households is forecast to be £2000 per annum higher, leading to an increase in annual repayments for the UK household sector of £15.8 billion.

Chart 3 provides a visual picture of the typical annual repayment costs facing first-time buyers as a percentage of earnings after tax and national insurance (click here for a PowerPoint). The Nationwide Building Society figures are based on an 80% loan on the typical first-time buyer house price. It shows that repayment costs have been rising sharply on the back of rising interest rates and are now higher than at any time since the global financial crisis of 2007–8.

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Data

Questions

  1. What possible indicators could be used to assess the affordability of residential house prices?
  2. What is captured by the rate of core inflation? Discuss the arguments for using this as the target inflation rate measure.
  3. What factors might affect the proportion of people taking out fixed-rate mortgages rather than variable-rate mortgages?
  4. Discuss the ways by which house price changes could impact on household consumption.
  5. Investigate the proportion of mortgages that are fixed rate and the typical length of the fixed rate term in two European countries, the USA and Japan. How does each differ from the UK?
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Bank failures and the importance of balance sheets

March 2023 saw the failure of Silicon Valley Bank (SVB), a regional US bank based in California that focused on financial services for the technology sector. It also saw the forced purchase of global-banking giant, Credit Suisse, by rival Swiss bank, UBS. These events fuelled concerns over the banking sector’s financial well-being, with fears for other financial institutions and the wider economy.

Yet it is not the only sector where concerns abound over financial well-being. The cost-of-living crisis, the hike in interest rates and the economic slowdown continue to have an adverse impact on the finances of households and businesses. Furthermore, many governments face difficult fiscal choices in light of the effects of recent economic shocks, such as COVID and the Russian invasion of Ukraine, on the public finances.

Balance sheets and flow accounts

When thinking about the financial well-being of people, business and governments it is now commonplace for economists to reference balance sheets. This may seem strange to some since it is easy to think of balance sheets as the domain of accountants or those working in finance. Yet balance sheets, and the various accounts that lie behind them, are essential in analysing financial well-being and, therefore, in helping to understand economic behaviour and outcomes. Hence, it is important for economists to embrace them too.

A balance sheet is a record of stocks of assets and liabilities of individuals or organisations. Behind these stocks are accounts capturing flows, including income, expenditure, saving and borrowing. There are three types of flow accounts: income, financial and capital. Together, the balance sheets and flow accounts provide important insights into the overall financial position of individuals or organisations as well as the factors contributing to changes in their financial well-being.

The stock value of a sector’s or country’s non-financial assets and its net financial worth (i.e. the balance of financial assets over liabilities) is referred to as its net worth. Non-financial assets include produced assets, such as dwellings and other buildings, machinery and computer software, and non-produced assets, largely land.

An increase in the net worth of the sectors or the whole country implies greater financial well-being, while a decrease implies greater financial stress. Yet a deeper understanding of financial well-being also requires an analysis of the composition of the balance sheets as well as their potential vulnerabilities from shocks, such as interest rate rises, falling asset prices or borrowing constraints.

UK net worth

The chart shows the UK’s stock of net worth since 1995, alongside its value relative to annual national income (GDP) (click here for a PowerPoint). In 2021, the net worth of the UK was £11.8 trillion, equivalent to 5.2 times the country’s annual GDP. This marked an increase of £1.0 trillion or 9 per cent over 2020. This was driven largely by an increase in land values (non-produced non-financial assets).

In contrast, the stock of net worth fell in both 2008 and 2009 at the height of the financial crisis and the ensuing economic slowdown, which contributed to the country’s net worth falling by over 8 per cent.

The chart shows that net financial assets continue to make a negative contribution to the country’s net worth. In 2021 financial liabilities exceeded financial assets by the equivalent of 19 per cent of annual national income.

Non-financial corporations and the public sector together had financial liabilities in excess of financial assets of £3.4 trillion and £2.5 trillion respectively. However, once non-financial assets are accounted for, non-financial corporations had a positive net worth of £607 billion, although their value was not sufficient to prevent the public sector having a negative net worth of £1.2 trillion. Meanwhile, households had a positive net worth of £11.4 trillion and financial corporations a negative net worth of £4.9 billion.

Vulnerabilities and the balance sheets

The collapse of Silicon Valley Bank (SVB) resulted from balance sheet distress. Some argue that this distress can be attributed to a mismanagement of the bank’s liquidity position, which saw the bank use the surge in funds, on the back of buoyant activity among technology companies, to purchase long-dated bonds while, at the same time, reducing the share of assets held in cash. However, as the growth of the technology sector slowed as pandemic restrictions eased and, crucially, as central banks, including the Federal Reserve, began raising rates, the value of these long-dated bonds fell. This is because there is a negative relationship between interest rates and bond prices. Bonds pay a fixed rate of interest and so as other interest rates rise, bonds become less attractive to savers, pushing down their price. As depositors withdrew funds, Silicon Valley Bank found itself increasingly trying to generate liquidity from assets whose value was falling.

A major problem with balance sheet distress is contagion. This can occur, in part, because of what is known as ‘counterparty risk’. This simply refers to the idea that one party’s well-being is tied directly to that of another. However, the effects on economies from counterparty risks can be amplified by their impact on general credit conditions, confidence and uncertainty. This helps to explain why the US government stepped in quickly to guarantee SVB deposits.

There is, however, a ‘moral hazard’ problem here: if central banks are always prepared to step in, it can signal to banks that they are too big to fail and disincentivise them for adopting appropriate risk management strategies in the first place.

Subsequently, First Citizens Bank acquired the commercial banking business of SVB, while its UK subsidiary was acquired by HSBC for £1.

Interest rates and financial well-being

In light of the failures of SVB and Credit Suisse, the raising of interest rates by inflation-targeting central banks has raised concerns about the liquidity and liabilities positions of banks and non-bank financial institutions, such as hedge funds, insurers and pension funds. As we have seen, higher interest rates push down the value of bonds, which form a major part of banks’ balance sheets. The problem for central banks is that, if this forced them to make large-scale injections of liquidity by buying bonds (quantitative easing), it would make the fight against inflation more difficult. Quantitative easing is the opposite of tightening monetary policy and thus credit conditions, which are seen as necessary to control inflation.

Yet the raising of interest rates has implications for the financial well-being of other sectors too since they also are affected by the effects on asset values and debt-servicing costs. For example, raising interest rates has a severe impact on the cashflow of UK homeowners with large variable-rate mortgages. This can substantially affect their spending. The UK has a high proportion of homeowners on variable-rate mortgages or fairly short-term fixed-rate mortgages. Also for a large number of households their mortgages are high relative to their incomes.

In short, falling asset values and increasing debt-servicing costs from rising interest rates in response to rising inflation tends to dampen spending in the economy. The effects will be larger the more burdened with debt people and businesses are, and the less liquidity they have to access. This has the potential to lead to a financial consolidation in order to restore the well-being of balance sheets. This involves cutting borrowing and spending.

Such a consolidation could be exacerbated if financial institutions become distressed and if it were to result in even larger numbers of people and businesses facing greater restrictions in accessing credit. These balance sheet pressures will continue to weigh on the policy responses of central banks as they attempt to navigate economies out of the current inflationary pressures.

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Questions

  1. What is recorded on a balance sheet? Explain with reference to the household sector.
  2. What is meant by net worth? Does an increase in net worth mean that an individual’s or sector’s financial well-being has increased?
  3. What is meant by ‘liquidity-constrained’ individuals or businesses? What factors might explain how liquidity constraints arise?
  4. It is sometimes argued that there is a predator-prey relationship between income and debt. How could such a relationship arise and what is its importance for the economy?
  5. Why might a deterioration of a country’s balance sheets have both national and international consequences?
  6. Explain the possible trade-offs facing central banks when responding to inflationary pressures.
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Inflation targeting and policy trade-offs

The mandates of central banks around the world are typically focused on controlling inflation. In many cases, this is accompanied by operational independence from government, but with the government setting an inflation target. The central bank then chooses the appropriate monetary policy to achieve the inflation target. This is argued to provide the conditions that can deliver lower and less variable inflation rates – at least over the longer term.

However, some economists argue that this has the potential to create the conditions for greater economic volatility and financial instability. The events surrounding the collapse of Silicon Valley Bank (SVB) – the largest since the global financial crisis – have helped to reignite these debates.

Inflation targeting central banks

The theoretical foundations for delegating monetary policy to central banks with mandates to meet an inflation rate target is often attributed to the paper of Fynn Kydland and Edward Prescott published in the Journal of Political Economy in 1977. It argues that if governments, rather than independent central banks, operate monetary policy, systemically-high inflation can become established if low-inflation announcements by governments lack credibility. Delegation of monetary to a central bank with an inflation rate target, however, can create the necessary conditions for credibility. This, in turn, gives the public confidence to maintain lower and more stable inflationary expectations than would otherwise be the case.

To mitigate the problem of a potential inflationary bias, it is argued that governments should delegate monetary policy to a conservative central banker: one that places less weight on output or employment stabilisation and more weight on inflation stabilisation than does society. However, as identified by Kenneth Rogoff in his paper published in the Quarterly Journal of Economics in 1985, this raises the spectre of greater volatility in output and employment when economies are buffeted by supply shocks.

Inflation–output stabilisation trade-off

The inflation–output stabilisation trade-off identified by Rogoff has particular relevance to the macroeconomic environment experienced by many countries in recent times. As economies began to open up after the pandemic, demand–supply imbalances saw the emergence of inflationary pressures. These pressures were then exacerbated by the Russian invasion of Ukraine, which drove up commodity prices.

Rather than pursuing a less contractionary policy in the face of these supply shocks so as to avoid recession, central banks stuck to their inflation mandates and hence raised interest rates significantly so as to bring inflation back to target as soon as possible. But this hampered economic recovery.

Inflation–financial stability trade-off

Yet the recent financial turmoil suggests a further inflation–stability trade-off: an inflation–financial stability trade-off. By raising interest rates, different sectors of the economy are liable to greater financial distress. This distress has contributed to the collapse of Silicon Valley Bank and Signature Bank, and led to a significant injection of funds by large US banks into First Republic. The fear is of a contagion within the financial sector, which then spills into other sectors of the economy.

The debate about central bank mandates and the weight attached to inflation stability relative to other objectives is therefore centre stage of macroeconomic policy debates.

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Questions

  1. Explain the argument that the delegation of monetary policy can help to keep the average rate of inflation lower.
  2. How might the monetary policy responses of central banks to an inflation shock create the possibility of an inflation–output stabilisation trade-off?
  3. What do you understand by a Taylor rule? Could this help to alleviate the inflation-output stabilisation trade-off?
  4. Some economists argue that there is less of a trade-off between inflation and output stability with demand-pull inflation because of a so-called ‘divine coincidence’ in monetary policy. Why might this be the case?
  5. What do you understand by the term ‘financial distress’? What metrics could be used to capture this for different sectors of the economy?
  6. Explain how financial contagion can spread both within and between different sectors of the economy.
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Getting real with growth

To make a sensible comparison of one year’s national income generated from the production of goods and services with another we need to take inflation into account. Changes in inflation-adjusted GDP represent changes in the volume of production of a country’s goods and services: in other words, the real value of goods and services. We revisit the blog written back in April 2019, prior the pandemic, to show how changes in real GDP evidence what we may refer to as the twin characteristics of economic growth: positive long-term growth but with fluctuating short-term rates of growth.

Real and nominal GDP

The nominal or current-price estimate for UK Gross Domestic Product in 2020 is £2.156 trillion. It is the value of output produced within the country in 2020. This was a fall of 4.4 per cent on the £2.255 trillion recorded in 2019. These values make no adjustment for inflation and therefore reflect the prices of output that were prevailing at the time.

Chart 1 shows current-price estimates of GDP from 1950 when the value of GDP was estimated at £12.7 billion. The increase to £2.156 trillion in 2020 amounts to a proportionate increase of almost 170 times, a figure that rises to 211 times if we compare the 1950 value with the latest IMF estimate for 2025 of £2.689 trillion. However, if we want to make a more meaningful comparison of the country’s national income by looking at the longer-term increase in the volume of production, we need to adjust for inflation. (Click here to download a PowerPoint copy of the chart.)

Long-term growth in real GDP

If we measure GDP at constant prices, we eliminate the effect of inflation. To construct a constant-price series for GDP a process known as chain-linking is used. This involves taking consecutive pairs of years, e.g. 2020 and 2021, and estimating what GDP would be in the most recent year (in this case, 2021) if the previous year’s prices (i.e. 2020) had continued to prevail. By calculating the percentage change from the previous year’s GDP value we have an estimate of the volume change. If this is repeated for other pairs of years, we have a series of percentage changes that capture the volume changes from year-to-year. Finally, a reference year is chosen and the percentage changes are applied backwards and forwards from the nominal GDP value for the reference year – the volume changes forwards and backwards from this point.

In effect, a real GDP series creates a quantity measure in monetary terms. Chart 1 shows GDP at constant 2019 prices (real GDP) alongside GDP at current prices (nominal GDP). Consider first the real GDP numbers for 1950 and 2020. GDP in 1950 at 2019 prices was £410.1 billion. This is higher than the current-price value because prices in 2019 (the reference year) were higher than those in 1950. Meanwhile, GDP in 2020 when measured at 2019 prices was £2.037 trillion. This constant-price value is smaller than the corresponding current-price value because prices in 2019 where lower than those in 2020.

Between 1950 and 2020 real GDP increased 5.0 times. If we extend the period to 2025, again using the latest IMF estimates, the increase is 5.9 times. Because we have removed the effect of inflation, the real growth figure is much lower than the nominal growth figure. Crucially, what we are left with is an indicator of the long-term growth in the volume of the economy’s output and hence an increase in national income that is backed up by an increase in production. Whereas nominal growth rates are affected both by changes in volumes and prices, real growth rates reflect only changes in volumes.

The upward trajectory observed in constant-price GDP is therefore evidence of positive longer-term growth. This is one of the twin characteristics of growth.

Short-term fluctuations in the growth of real GDP

The second characteristic is fluctuations in the rate of growth from period to period. We can see this second characteristic more clearly by plotting the percentage change in real GDP from year to year.

Chart 2 shows the annual rate of growth in real GDP each year since 1950. From it, we see the inherent instability that is a key characteristic of the macroeconomic environment. This instability is, of course, mirrored in the output path of real GDP in Chart 1, but the annual rates of growth show the instability more clearly. We can readily see the impact on national output of the global financial crisis and the global health emergency.

In 2009, constant-price GDP in the UK fell by 4.25 per cent. Then, in 2020, constant-price GDP and, hence, the volume of national output fell by 9.7 per cent, as compared to a 4.4 per cent fall in current-price GDP that we identified earlier. These global, ‘once-in-a-generation’ shocks are stark examples of the instability that characterises economies and which generate the ‘ups and downs’ in an economy’s output path, known more simply as ‘the business cycle’. (Click here to download a PowerPoint copy of the chart.)

Determinants of long-and short-term growth

The twin characteristics of growth can be seen simultaneously by combining the output path captured by the levels of real GDP with the annual rates of growth. This is shown in Chart 3. The longer-term growth seen in the economy’s output path is generally argued to be driven by the quantity and quality of the economy’s resources, and their effectiveness when combined in production. In other words, it is the supply-side that determines the trajectory of the output path over the longer term. (Click here to download a PowerPoint copy of the chart.)

However, the fluctuations we observe in short-term growth rates tend to reflect impulses that affect the ability and or willingness of producers to supply (supply-side shocks) and purchasers to consume (demand-side shocks). These impulses are then propagated and their effects, therefore, transmitted through the economy.

Effects of the pandemic

The pandemic is unusual in that the health intervention measures employed by governments around the world resulted in simultaneous negative aggregate demand and aggregate supply shocks. Economists were particularly concerned that the magnitude of these impulses and their propagation had the potential to generate scarring effects and hence negative hysteresis effects. The concern was that these would affect the level of real GDP in the medium-to-longer term and, hence, the vertical position of the output path, as well as the longer-term rate of growth and, hence, the steepness of the output path.

The extent of these scarring effects continues to be debated. The ability of businesses and workers to adapt their practices, the extraordinary fiscal and monetary measures that were undertaken in many countries, and the roll-out of vaccines programmes, especially in advanced economies, have helped to mitigate some of these effects. For example, the latest IMF forecasts for output in the USA in 2024 are over 2 per cent higher than those made back in October 2019.

Scarring effects are, however, thought to be an ongoing issue in the UK. The IMF is now expecting output in the UK to be nearly 3 per cent lower than it originally forecast back in October 2019. Therefore, whilst UK output is set to recover, scarring effects on the UK economy will mean that the output path traced out by real GDP will remain, at least in the medium term, vertically lower than was expected before the pandemic.

Data and Reports

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Questions

  1. What do you understand by the term ‘macroeconomic environment’? What data could be used to describe the macroeconomic environment?
  2. When a country experiences positive rates of inflation, which is higher: nominal economic growth or real economic growth?
  3. Does an increase in nominal GDP mean a country’s production has increased? Explain your answer.
  4. Does a decrease in nominal GDP mean a country’s production has decreased? Explain your answer.
  5. Why does a change in the growth of real GDP allow us to focus on what has happened to the volume of production?
  6. What does the concept of the ‘business cycle’ have to do with real rates of economic growth?
  7. When would falls in real GDP be classified as a recession?
  8. Distinguish between the concepts of ‘short-term growth rates’ and ‘longer-term growth’.
  9. What do you understand by the term hysteresis? By what means can hysteresis effects be generated?
  10. Discuss the proposition that the pandemic could have a positive effect on longer-term growth rates because of the ways that people and business have had to adapt.
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Public spending and receipts: a pandemic displacement effect?

The COVID-19 pandemic had a stark effect on countries’ public finances. Governments had to make difficult fiscal choices around spending and taxation to safeguard public health, and the protection of jobs and incomes both in the present and in the future. The fiscal choices were to have historically large effects on the size of public spending and on the size of public borrowing.

Here we briefly summarise the magnitude of these effects on public spending, receipts and borrowing in the UK.

The public sector comprises both national government and local or regional government. In financial year 2019/20 public spending in the UK was £886 billion. This would rise to £1.045 trillion in 2020/21. To understand better the magnitude of these figures we can express them as a share of national income (Gross Domestic Product). In 2019/20 public spending was 39.8 per cent of national income. This rose to 52.1 per cent in 2020/21. Meanwhile, public-sector receipts, largely taxation, fell from £829.1 billion in 2019/20 to £796.5 billion in 2020/21, though, because of the fall in national income, the share of receipts in national income rose very slightly from 37.3 to 37.9 per cent of national income.

The chart shows both public spending and public receipts as a share of national income since 1900. (Click here for a PowerPoint of the chart.) What this chart shows is the extraordinary impact of the two World Wars on the relative size of public spending. We can also see an uptick in public spending following the global financial crisis and, of course, the COVID-19 pandemic. The chart also shows that spending is typically larger than receipts meaning that the public sector typically runs a budget deficit. .
If we focus on public spending as a share of national income and its level following the two world wars, we can see that it did not fall back to pre-war levels. This is what Peacock and Wiseman (1961) famously referred to as a displacement effect. They attributed this to, among other things, an increase in the public’s tolerance to pay higher taxation because of the higher taxes levied during the war as well as to a desire for greater public intervention. The latter arose from an inspection effect. This can be thought of as a public consciousness effect, with the war helping to shine a light on a range of economic and social issues, such as health, housing and social security. These two effects, it is argued, reinforced each other, allowing the burden of taxation to rise and, hence, public spending to increase relative to national income.

If we forward to the global financial crisis, we can again see public spending rise as a share of national income. However, this time the ratio did not remain above pre-crisis levels. Rather, the UK government was fearful of unsustainable borrowing levels and the crowding out of private-sector activity by the public sector, with higher interest rates making public debt an attractive proposition for investors. It thus sought to reduce the public-sector deficit by engaging in what became known as ‘austerity’ measures.

If we move forward further to the COVID-19 pandemic, we see an even more significant spike in public spending as a share of national income. It is of course rather early to make predictions about whether the pandemic will have enduring effects on public spending and taxation. Nonetheless the pandemic, in a similar way to the two world wars, has sparked public debates on many economic and social issues. Whilst debates around the funding of health and social care are longstanding, it could be argued that the pandemic has provided the government with the opportunity to introduce the 1.25 percentage point levy from April 2022 on the earned incomes of workers (both employees and the self-employed) and on employers. (See John’s blog Fair care? for a fuller discussion on the tax changes to pay for increased health and social care expenditure).

The extent to which there may be a pandemic displacement effect will depend on the fiscal choices made in the months and years ahead. The key question is how powerful will be the effect of social issues like income and wealth inequality, regional and inter-generational disparities, discrimination, poor infrastructure and educational opportunities in shaping these fiscal choices? Will these considerations carry more weight than the push to consolidate the public finances and tighten the public purse? These fiscal choices will determine the extent of any displacement effect in public spending and taxation.

Reference

Alan Peacock and Jack Wiseman, The Growth in Public Expenditure in the United Kingdom, Princeton University Press (1961).

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Questions

  1. What do you understand by the term ‘public finances’?
  2. Why might you wish to express the size of public spending relative to national income rather than simply as an absolute amount?
  3. Undertake research to identify key pieces of social policy in the UK that were enacted at or around the times of the two World Wars.
  4. What do you understand by the terms ‘tolerable tax burden’ and ‘inspection effect’?
  5. Identify those social issues that you think have come into the spotlight as a result of the pandemic. Undertake research on any one of these and write a briefing note exploring the issue and the possible policy choices available to government.
  6. What is the concept of crowding out? How might it affect fiscal choices?
  7. How would you explain the distinction between public-sector borrowing and public-sector debt? Why could the former fall and the latter rise at the same time?