How rise in debt became a two-edged sword for economy
Tuesday, 2 August 2005
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The explosion in consumer debt to record levels has staved off a recession in the UK but may prove to be a poisoned chalice for the Bank of England when it comes to setting interest rates.
The Bank is expected to cut rates on Thursday in response to a marked economic slowdown that has shown up particularly in the consumer and housing sectors.
Its Monetary Policy Committee cut rates savagely to 3.5 per cent in the wake of the 11 September 2001 terror attacks on the US and the Iraq war, but then swiftly hiked them by 40 per cent as homebuyers took advantage of cut-price mortgage deals.
With the stock of debt bursting through £1 trillion (£1,000bn), the rate rises appear to have put the brakes on the economy more effectively than in the past.
The recent behaviour of monetary policy and consumer spending could imply that rates must now hover within a much narrower band than in the past.
If the MPC does cut rates, then 4.75 per cent will turn out to be the lowest peak in rates since 1952, and well below the range of 5.0-5.5 per cent some on the MPC see as a "neutral rate".
"We have moved into a new world," John Butler, the UK economist at HSBC, said. "It is a difficult position that the Bank of England is in."
He said that as inflation fell over the past decade the peak in rates has moved successively lower. "The reason they are peaking at these levels is that consumers are more sensitive to interest rates than in the past," he said. "The flipside is that if the big issue is a slowdown in consumer spending and we cut rates too early then there's a risk that we succeed in encouraging consumers to take on more debt."
With all but four City economists forecasting a cut on Thursday, the issue is swiftly moving on to whether this is a one-off or the first of many.
Philip Shaw, the chief UK economist at Investec, said the MPC would be cautious in "untwisting the monetary screw" too quickly. "We expect a degree of wariness over providing UK consumers with stimulus that they might not need," he said.
But Vicky Redwood at Capital Economics, which forecasts rates falling to 3.5 per cent, said there were many other factors than rates affecting the housing market.
"A small reduction in interest rates will not suddenly prompt more people to go out and get into more debt," she said, adding that high prices would continue to act as a dampener on the market.
The Bank has indicated it believes that it still has room to manoeuvre despite high levels. As Ms Redwood said: "You can point to figures showing an increase in the number of people struggling to pay their debts but it is a very small minority of people. It is worrying to see it but it is not like the early 1990s all over again." It seems as if the second half of the year will test the one maxim that has seldom let economists down is - "Never underestimate the British consumer".
Through a sequence of shocks to the UK and global economy - the Asian financial crisis, the Russian debt default, 9/11, the Iraq war, the oil price spike and finally the London bombings - shoppers and homebuyers have carried on almost regardless. The question for the Bank is consumers will continue to hold their nerve.
