When rates hinge on expectations great and small

Economic View

We are richer than ever before. The UK personal sector's net wealth stood at around pounds 2,800bn at the end of last year - an increase of more than 80 per cent since 1980, even after allowing for the effects of inflation.

Yet it has taken four years, with interest rates close to their lowest levels for a generation, to spark only a modest recovery in the housing market, and despite the tax cuts announced in last November's Budget, consumer spending this year will rise at only half the pace reached in the late 1980s.

There is more to this reluctance to spend money than the conventional story of job insecurity suggests. There are hard financial reasons too. In many ways, consumers behaved during the 1980s like over-extended companies, building up the size of the balance sheet without regard to short-term considerations like the need to maintain some cushion against future shocks, such as rising interest rates.

When it comes to liquidity - the ability to pay the bills on time - the structure of the balance sheet matters more than its size. During the 1980s, the rise in the personal sector's wealth was dominated by two factors: the housing market boom; and the explosion in the value of holdings of life assurance and pension funds, which together accounted for two-thirds of the increase in gross personal assets between 1980 and 1994. Liquid assets, mostly bank and building society deposits, rose much less quickly than the stock of debt, most of which was acquired in order to buy houses. Later, an increasing proportion of the debt burden represented equity withdrawal as houses became the provider of funds for exotic holidays, boats, and new cars. All the while, however, the ability of consumers to cope with a sudden upturn in interest rates was being eroded: the ratio of consumers' liquid assets to their base rate-linked debts was falling, even though their total wealth was rising rapidly. The headline numbers said that consumers were growing ever richer, but the devil in the details said that they were becoming ever more susceptible to changes in policy. When the crunch came, with interest rates doubling to 15 per cent between May 1988 and October 1989, consumers were hit much harder than previous experience would have suggested.

Just as over-geared companies find it difficult to sell pieces of machinery to meet interest charges, so householders cannot, in aggregate, sell their properties to avoid the pain of higher mortgage rates. It is possible for some individuals to do this, especially in the early stages of a downturn, but it is not an option open to everyone.

It took a while for higher rates to do their work - after all, when rates began to rise the boom had acquired its own momentum - but eventually the housing explosion subsided as would-be buyers looked askance at 15 per cent mortgage rates when average earnings were rising at 9 per cent.

The subsequent fall in nominal house prices has been instrumental in forcing people to recognise the extent to which the changing structure of the balance sheet has increased their exposure to the effects of higher interest rates. Consumers have become sensitive to a level of interest rates - and to small changes in interest rate expectations - which only a few years ago would have had no effect at all.

The best evidence for this effect comes from the housing market. The graphic (top right) shows that the violent swings in mortgage approvals over the past few years have been more or less entirely explained by shifts in the markets' expectations about future interest rates moves. In comparison, the reductions in mortgage interest tax relief have had a trivial effect on the market.

There are at least two mechanisms which explain why expectations have become so much more important. The first is the rise of the fixed-rate mortgage, which came from nowhere to capture 63 per cent of the new mortgage market in the second quarter of 1994. Fixed rates are driven more or less mechanically by the market-determined yield on short-dated gilts, so rising expectations of short rates, which lift gilt yields, push up the cost of fixed-rate mortgages. This was certainly the case in 1994, when short-rate expectations rose sharply after the US Fed increased rates unexpectedly. Gilt yields rose sharply, and fixed-mortgage rates rose by around 2 per cent in less than two months.

The housing market duly plunged, and the share of fixed-rate mortgages fell to only 31 per cent by the end of the year.

The second factor is more subtle. The markets' expectations of future base rates are not particularly reliable, for they tend to exaggerate actual moves in base rates in both directions. But because they are technically unbiased (unlike the views of economists) and available on a real-time basis to anyone with a newswire screen, they are often used by the media as a convenient guide. Short sterling rates therefore have an important impact on how monetary policy is discussed by the newspapers, in the personal finance as well as the economics columns. This was certainly the case in the spring of last year, when short sterling was discounting base rates at around 8.5 per cent by March 1996, despite base rates then standing at only 6.75 per cent.

The markets noted that base rates had been increased three times in half-point stages in five months, starting in September 1994, and they expected a similar rate of increase over the next year. Mortgage demand promptly collapsed, despite the standard variable mortgage rate rising by only 0.75 per cent from its low.

The turnaround in the summer was equally fast, after Mr Clarke defied requests for higher interest rates from the Governor of the Bank of England in May and June. The markets' view of the likely future paths of short rates plunged by more than 2 per cent and mortgage demand began to recover rapidly. Yet actual base rates were unchanged between February and December. If the change in consumers' sensitivity to interest rate expectations is effectively permanent (and the modest easing of the liquidity problem shown on the chart suggests that it is likely to persist for many years) then it is both a blessing and a curse to the authorities. On the upside, the absolute level of interest rates is likely to remain very low by the standards of the Seventies and Eighties, and the increases which might be necessary in the future to reduce the risk of inflation should also be much smaller than we have become used to. But the flipside is that if the markets don't like the Budget in November, perhaps because unsustainable tax cuts are offered, then interest rate expectations will rise, and the housing recovery could be snuffed out - just in time for the election.

The author is Chief UK Economist at HSBC Markets.