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.
- UK inflation to fall to lowest level since March 2022 but Bank of England still tipped to hike interest rates
City A.M., Jack Barnett (17/7/23)
- UK inflation and interest rates high – how do other economies compare?
BBC News, Dharshini David (23/7/23)
- Mortgage payments set to jump by £500 for one million households
BBC News, Tom Espiner (13/7/23)
- Interest rates: Big rise less likely after inflation surprise
BBC News, Daniel Thomas, Faisal Islam & Dharshini David (19/7/23)
- Rising Mortgage Costs. What Can Be Done?
NIESR blog, Max Mosley and Adrian Pabst (17/7/23)
- UK interest rates forecast to rise less sharply after inflation falls to 7.9%
The Guardian, Richard Partington (19/7/23)
- Mortgage costs: More Scots falling behind on repayments
Herald Scotland, Kristy Dorsey (18/7/23)
- The Mortgage Crunch
Resolution Foundation, Simon Pittaway (17/6/23)
- Peaked Interest?
Resolution Foundation, Molly Broome, Ian Mulheirn and Simon Pittaway (17/7/23)
- What possible indicators could be used to assess the affordability of residential house prices?
- What is captured by the rate of core inflation? Discuss the arguments for using this as the target inflation rate measure.
- What factors might affect the proportion of people taking out fixed-rate mortgages rather than variable-rate mortgages?
- Discuss the ways by which house price changes could impact on household consumption.
- 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?
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.
- What is recorded on a balance sheet? Explain with reference to the household sector.
- 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?
- What is meant by ‘liquidity-constrained’ individuals or businesses? What factors might explain how liquidity constraints arise?
- 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?
- Why might a deterioration of a country’s balance sheets have both national and international consequences?
- Explain the possible trade-offs facing central banks when responding to inflationary pressures.
Consumer credit is borrowing by individuals to finance current expenditure on goods and services. Consumer credit is distinct from lending secured on dwellings (referred to more simply as ‘secured lending’). Consumer credit comprises lending on credit cards, lending through overdraft facilities and other loans and advances, for example those financing the purchase of cars. We consider here recent trends in the flows of consumer credit in the UK and discuss their implications.
Analysing consumer credit data is important because the growth of consumer credit has implications for the financial wellbeing or financial health of individuals and, of course, for financial institutions. As we shall see shortly, the data on consumer credit is consistent with the existence of credit cycles. Cycles in consumer credit have the potential to be not only financially harmful but economically destabilising. After all, consumer credit is lending to finance spending and therefore the amount of lending can have significant effects on aggregate demand and economic activity.
Data on consumer credit are available monthly and so provide an early indication of movements in economic activity. Furthermore, because lending flows are likely to be sensitive to changes in the confidence of both borrowers and lenders, changes in the growth of consumer credit can indicate turning points in the economy and, hence, in the macroeconomic environment.
Chart 1 shows the annual flows of net consumer credit since 2000 – the figures are in £ billions. Net flows are gross flows less repayments. (Click here to download a PowerPoint copy of the chart.) In January 2005 the annual flow of net consumer credit peaked at £23 billion, the equivalent of just over 2.5 per cent of annual disposable income. This helped to fuel spending and by the final quarter of the year, the economy’s annual growth rate had reached 4.8 per cent, significantly about its long-run average of 2.5 per cent.
By 2009 net consumer credit flows had become negative. This meant that repayments were greater than additional flows of credit. It was not until 2012 that the annual flow of net consumer credit was again positive. Yet by November 2016, the annual flow of net consumer credit had rebounded to over £19 billion, the equivalent of just shy of 1.5 per cent of annual disposable income. This was the largest annual flow of consumer credit since September 2005.
Although the strength of consumer credit in 2016 was providing the economy with a timely boost to growth in the immediate aftermath of the referendum on the UK’s membership of the EU, it nonetheless raised concerns about its sustainability. Specifically, given the short amount of time that had elapsed since the financial crisis and the extreme levels of financial distress that had been experienced by many sectors of the economy, how susceptible would people and organisations be to a future economic slowdown and/or rise in interest rates?
The extent to which the economy experiences consumer credit cycles can be seen even more readily by looking at the 12-month growth rate in the net consumer credit. In essence, this mirrors the growth rate in the stock of consumer credit. Chart 2 evidences the double-digit growth rates in net consumer credit lending experienced during the first half of the 2000s. Growth rates then eased but, as the financial crisis unfolded, they plunged sharply. (Click here to download a PowerPoint copy of the chart.)
Yet, as Chart 2 shows, consumer credit growth began to recover quickly from 2013 so that by 2016 the annual growth rate of net consumer credit was again in double figures. In November 2016 the 12-month growth rate of net consumer credit peaked at 10.9 per cent. Thereafter, the growth rate has continually eased. In January 2019 the annual growth rate of net consumer credit had fallen back to 6.5 per cent, the lowest rate since October 2014.
The easing of consumer credit is likely to have been influenced, in part, by the resumption in the growth of real earnings from 2018 (see Getting real with pay). Yet, it is hard to look past the economic uncertainties around Brexit.
Uncertainty tends to cause people to be more cautious. With the heightened uncertainty that has has characterised recent times, it is likely that for many people and businesses prudence has dominated impatience. Therefore, in summary, it appears that prudence is helping to steer borrowing along a downswing in the credit cycle. As it does, it helps to put a further brake on spending and economic growth.
- What is the difference between gross and net lending?
- Consider the argument that we should be worried more by excessive growth in consumer credit than on lending secured on dwellings?
- How could we measure whether different sectors of the economy had become financially distressed?
- What might explain why an economy experiences credit cycles?
- Explain how the growth in net consumer credit can affect economic activity?
- If people are consumption smoothers, how can credit cycles arise?
- What are the potential policy implications of credit cycles?
- It is said that when making financial decisions people face an inter-temporal choice. Explain what you understand this by this concept.
- If economic uncertainty is perceived to have increased how could this affect the consumption, saving and borrowing decisions of people?
The Christmas and new year period often draws attention to the financial well-being of households. An important determinant of this is the extent of their indebtedness. Rising levels of debt mean that increasing amounts of households’ incomes becomes prey to servicing debt through repayments and interest charges. They can also result in more people becoming credit constrained, unable to access further credit. Rising debt levels can therefore lead to a deterioration of financial well-being and to financial distress. This was illustrated starkly by events at the end of the 2000s.
The total amount of lending by monetary financial institutions to individuals outstanding at the end of October 2018 was estimated at £1.61 trillion. As Chart 1 shows, this has grown from £408 billion in 1994. Hence, indivduals in the UK have experience a four-fold increase in the levels of debt. (Click here to download a PowerPoint of the chart.)
The debt of individuals is either secured or unsecured. Secured debt is debt secured by property, which for individuals is more commonly referred to as mortgage debt. Unsecured debt, which is also known as consumer credit, includes outstanding debt on credit cards, overdrafts on current accounts and loans for luxury items such as cars and electrical goods. The composition of debt in 2018 is unchanged from that in 1994: 87 per cent is secured debt and 13 per cent unsecured debt.
The fourfold increase in debt is taken by some economists as evidence of financialisation. While this term is frequently defined in distinctive ways depending upon the content in which it is applied, when viewed in very general terms it describes a process by which financial institutions and markets become increasingly important in everyday lives and so in the production and consumption choices that economists study. An implication of this is that in understanding economic decisions, behaviour and outcomes it becomes increasingly important to think about the potential impact of the financial system. The financial crisis is testimony to this.
In thinking about financial well-being, at least at an aggregate level, we can look at the relative size of indebtedness. One way of doing this is to measure the stock of individual debt relative to the annual flow of GDP (national income). This is illustrated in Chart 2. (Click hereto download a PowerPoint of the chart.)
The growth in debt among individuals owed to financial institutions during the 2000s was significant. By the end of 2007, the debt-to-GDP ratio had reached 88 per cent. Decomposing this, the secured debt-to-GDP ratio had reached 75 per cent and the unsecured debt-to-GDP ratio 13 per cent. Compare this with the end of 1994 when secured debt was 46 per cent of GDP, unsecured debt 7 per cent and total debt 53 per cent. In other words, the period between 1994 and 2007 the UK saw a 25 percentage point increase in the debt-to-GDP ratio of individuals.
The early 2010s saw a consolidation in the size of the debt (see Chart 1) which meant that it was not until 2014 that debt levels rose above those of 2008. This led to the size of debt relative to GDP falling back by close to 10 percentage points (see Chart 2). Between 2014 and 2018 the stock of debt has increased from around £1.4 trillion to the current level of £1.61 trillion. This increase has been matched by a similar increase in (nominal) GDP so that the relative stock of debt remains little changed at present at around 76 per cent of GDP.
Chart 3 shows the annual growth rate of net lending (lending net of repayments) by monetary financial institutions to individuals. This essentially captures the growth rate in the stocks of debt, though changes in the actual stock of debt are also be affected by the writing-off of debts. (Click here to download a PowerPoint of the chart.)
We can see quite readily the pick up in lending from 2014. The average annual rate of growth in total net lending since 2014 has been just a little under 3½ per cent. This has been driven by unsecured lending whose growth rate has been close to 8½ per cent per annum, compared to just 2.7 per cent for secured lending. In 2016 the annual growth rate of unsecured lending was just shy of 11 per cent. This helped to fuel concerns about possible future financial distress. These concerns remain despite the annual rate of growth in unsecured debt having eased slightly to 7.5 per cent.
Despite the aggregate debt-to-GDP ratio having been relatively stable of late, the recent growth in debt levels is clearly not without concern. It has to be viewed in the context of two important developments. First, there remains a ‘debt hangover’ from the financial distress experienced by the private sector at the end of the 2000s, which itself contributed to a significant decline in economic activity (real GDP fell by 4 per cent in 2009). This subequently affected the financial well-being of the public sector following its interventions to cushion the economy from the full effects of the economic downturn as well as to help stabilise the financial system. Second, there is considerable uncertainty surrounding the UK’s exit from the European Union.
The financial resilience of all sectors of the economy is therefore of acute concern given the unprecedented uncertainty we are currently facing while, at the same time, we are still feeling the effects of the financial distress from the financial crisis of the late 2000s. It therefore seems timely indeed for individuals to take stock of their stocks of debt.
- How might we measure the financial distress of individuals?
- If individuals are financially distressed how might this affect their consumption behaviour?
- How might credit constraints affect the relationship between consumption and income?
- What do you understand by the concept of ‘cash flow effects’ that arise from interest rate changes?
- How might the accumulation of secured and unsecured debt have different effects on consumer spending?
- What factors might explain the rate of accumulation of debt by individuals?
- What is meant by ‘financial resilience’ and why might this currently be of particular concern?
We have frequently looked at patterns in lending by financial institutions in our blogs given that many economies, like the UK, display cycles in credit. Central banks now pay considerable attention to the possibility of such cycles destabilising economies and causing financial distress to people and businesses. There is also increased interest here in the UK in bank lending data in light of Brexit. Patterns in credit flows may indicate whether it is affecting the lending choices of financial institutions and borrowing choices of people and businesses.
Data from the Bank of England’s Money and Credit – September 2016 statistical release shows net lending (lending net of repayments) by monetary financial institutions (MFIs) to individuals in September 2016 was £4.65 billion. This compares with £8.89 billion back in March 2016 which then was the highest monthly total since August 2007. However, the March figure was something of a spike in lending and this September’s figure is actually very slightly above the monthly average over the last 12 months, excluding March, of £4.5 billion. In other words, as yet, there is no discernible change in the pattern of credit flows post-Brexit.
Leaving aside the question of the economic impact of Brexit, we still need to consider what the credit data mean for financial stability and for our financial well-being. Chart 1 shows the annual flows of lending by banks and building societies since the mid 1990s. The chart evidences the cycles in secured lending and in consumer credit (unsecured lending) with its consequent implications for economic and financial-welling being.(Click here to download a PowerPoint of Chart 1.)
After the financial crisis, as Chart 1 shows, net lending to individuals collapsed. More recently, net lending has been on the rise both through secured lending and in consumer credit. The latest data show that annual flows have begun to plateau. Nonetheless, the total flow of credit in the 12 months to September of £58 billion compares with £33 billion and £41 billion in the 12 months to September 2014 and 2015 respectively. Having said this, in the 12 months to September 2007 the figure was £112 billion! £58 billion is currently equivalent to around about 3 per cent of GDP.
To more readily see the effect of the credit flows on debts stocks, Chart 2 shows the annual growth rate of net lending by MFIs. In essence, this mirrors the growth rate in the stocks of debt which is an important metric of financial well-being. The chart nicely captures the pick up in the growth of lending from around the start of 2013. What is particularly noticeable is the very strong rates of growth in net unsecured lending from MFIs. The growth of unsecured lending remains above 10 per cent, comparable with rates in the mid 2000s. (Click here to download a PowerPoint of Chart 2.)
The growth in debt stocks arising from lending continues to demonstrate the need for individuals to be mindful of their financial well-being. This caution is perhaps more important given the current economics uncertainties. The role of the Financial Policy Committee in the UK is to monitor the financial well-being of economic agents in the context of ensuring the resilience of the financial system. It therefore analyses the data on credit flows and debt stocks referred to in this blog along with other relevant metrics. At this moment its stance is not to apply any additional buffer – known as the Countercyclical Capital Buffer – on a financial institution’s exposures in the UK over and above internationally agreed standards. Regardless, the fact that it explicitly monitors financial well-being and risk shows just how significant the relationship between the financial system and economic outcomes is now regarded.
Higher inflation and rising debt threaten millions in UK The Guardian, Angela Monaghan (5/11/16)
Consumer spending has saved the economy in the past – but we cannot bet on it forever Sunday Express, Geff Ho (13/11/16)
Warning as household debts rise to top £1.5 trillion BBC News, Hannah Richardson (7/11/16)
Household debt hits record high – How to get back on track if you’re in the red Mirror, Graham Hiscott (7/12/16)
Money and Credit – September 2016 Bank of England
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database Bank of England
- Explain the difference between secured debt and unsecured debt.
- What does it mean if individuals are financially distressed?
- How would we measure the financial well-being of individuals and households?
- What actions might individuals take it they are financially distressed? What might the economic consequences be?
- How might uncertainty, such as that following the UK vote to leave the European Union, affect spending and savings’ decisions by households?
- What measures can institutions, like the UK’s Financial Policy Committee, take to reduce the likelihood that flows of credit become too excessive?