UK base rates: how important are they?

Recently announced inflation data from the US and UK economies has, as usual, been the subject of much debate in the media and amongst economic commentators. Consensus expectations for how rapidly inflation will fall from month to month attracts a lot of attention, and when the official data doesn’t quite meet those expectations, many column inches are devoted to the economic implications. In the UK, for example, the slightly higher-than-expected March CPI data has generated a lot of commentary about what this means for interest rate cuts in 2024. At the start of the year, it was reported that six quarter-point reductions in UK interest rates were expected based on the likely trajectory of UK inflation. Now, the market is apparently expecting only one. 

Of course, this then translates into a more downbeat commentary on the outlook for the economy. A City economist was quoted as saying that the change in market interest rate expectations would “hit household living standards and corporate profits” and, as a result, the UK economy could be on course for a “hard landing” from the inflation crisis. The article describes how this changed situation would also hit 1.6 million mortgage holders coming off fixed-rate deals this year. 

So far, no surprises. In general, and without wishing to generalise too much, the consensus view seems to be that without interest rate cuts, the outlook for the UK economy in 2024 is not good. To put this in context, consensus expectations for GDP growth in 2024 are around 0.4%.

Now, without wishing to be too controversial, I fundamentally disagree with this downbeat narrative. Let me start by saying something that may surprise you. Base rate cuts this year or next will have limited significance for the performance of the UK economy, which I expect to grow significantly faster than the consensus expects, even if rates are not cut at all. I will explain why I say this later in this blog.

But before I do, I just wanted to draw your attention to what’s been happening in the US, where the “sticky inflation” debate has been even louder than here. There, too, is the argument about the path of the FED funds rate, which is a dominant feature of market financial commentary. In general, expectations for the timing of the first cut and the number of subsequent cuts have been getting significantly more bearish. Yet, this is what has been happening to US economic growth in the absence of any cuts in official interest rates:

To put this growth into context, the US economy grew at an average of 2.4% in the ten years between 2010 and 2019. Growth in 2023 was 2.5%, and the IMF forecasts 2.7% growth for the US economy in 2024.

Clearly, the US economy is not the same as the UK's, but interestingly, the two economies have roughly the same interest rates, the same rate of inflation, similar 10-year bond yields, and the same rates of unemployment. But, on the face of it, high interest rates and an absence of policy easing are not stopping the US economy from delivering robust rates of growth. 

Now, I don’t intend to go into the detail of why this is happening in the US other than to say that its labour market has been very strong throughout this period and that, unsurprisingly, more people in work, combined with good wage growth, is good news for the consumer economy, which has been driving growth there (the economy added 2.7 million jobs in 2023).

So, why do I say that the MPC’s decisions on rates in 2024 are not that important for the growth outcome here in the UK?

By way of background, when thinking about the outlook for the UK economy, it is very hard to anticipate what the MPC will do to rates even if we had absolute clarity on the inflation outlook. That’s partly because the MPC members don’t know what they will do. Consequently, anchoring any economic forecast to anticipated rate decisions adds significant uncertainty to what is already an inherently uncertain process. My favourite UK economist’s forecasts for the UK economy are based on no rate change. He revisits his forecasts as and when the committee actually decides to change rates. Interestingly, he is not expecting to change his growth expectations even if rates are reduced.

To properly answer the question I have posed, I need to show you why changes in base rates have a much more limited impact on the UK economy than they used to. Let’s start with the UK’s aggregated consumer balance sheet. 

In aggregate, UK households’ bank deposits are now nearly £250 billion, larger than total household bank loans, which include mortgages. Back in 2010, loans exceeded deposits by £300bn.

Since 2013, there have also been fundamental changes in the structure of the UK mortgage market, which have an important bearing on the household sector’s sensitivity to base rates, as shown in the chart below.

With over 87% of the mortgage market now on fixed rates, and the vast majority of these being 5-year deals, the relationship between interest rate changes and the monthly mortgage payments households pay in aggregate has fundamentally changed. It is also important to remember that only about a third of the UK’s 29 million households have a mortgage. 

Consequently, and counterintuitively, because of these two important characteristics of the UK household sector (deposits greater than loans and the predominance of 5-year fixed-rate mortgages), when interest rates rose in 2022 and 2023, household cash flow in aggregate increased. This increase is clearly shown in the chart below.

This aggregate position doesn’t describe the circumstances of each UK household. In general, households with substantial bank deposits are unlikely to have mortgages, but this data clearly shows the aggregated position of all UK households.

As compelling as this data is, it is not the whole picture, so I decided to indulge in a thought experiment to illustrate my points better. In a hypothetical world where all mortgages in the UK are floating rate, each quarter-point change in interest rates would add or subtract £2.75 billion to total household cash flow.

Remember, the original media hypothesis was that with only one interest rate cut likely now in the UK instead of 6, the growth outlook is decidedly poor. So, assuming the MPC moves in quarter-point changes, in this hypothetical world, that’s only £2.75bn rather than £16.5bn at the other extreme, potentially added to household cash flow, assuming, in this hypothetical situation, that the banks passed on these changes to all mortgagors and that banks didn’t reduce deposit rates in tandem which would offset this benefit at least in part. 

The reality is that 87% of mortgages are fixed rate. So, at an aggregate level, quarter-point reductions in base rates will only affect those mortgage holders whose fixed rate deals are maturing this year (1.6mn households) and only then if lower base rate changes have an impact on five-year swap rates, which are what banks use to price 5-year mortgage offers. The reality is that base rate reductions, whether there is one or more this year, will have only a very limited impact on what all households with mortgages will pay in interest in 2024. 

This begs the question: If the household sector isn’t going to benefit from lower base rates in 2024, why am I upbeat about consumer spending growth? The answer is that household cash flow will see a significant boost from other factors whose scale dwarfs any benefits that may eventually accrue from looser monetary policy. 

Here is a list of the most important factors and an estimate of their quantum at an aggregate level. There may be others, such as growth in employment, but I have focused on these four because, in large part, they are already known.

1. The reduction in household energy bills in calendar 2024 will add roughly £15bn to household cash flow.
2. Pension incomes will increase by £10bn in fiscal 2024/25. (Triple lock)
3. Welfare spending will increase by £20bn in 2024/25 – Universal Credit, etc., indexed to September 2023’s inflation rate.
4. Post-tax wage growth combined with National Insurance reductions will add about 7% to take-home pay, which will add roughly £56bn to household cash flow in calendar year 2024.

These four alone will boost household cash flow by over £100bn in 2024. As you can now see, the combination of factors highlighted above dwarfs any change in the interest burden of households with mortgages. 

Another factor to remember is that the UK savings rate is currently high and above its long-term average, as shown in the chart below. This saving ratio implies that increases in household cash flow are more likely to be spent than saved, especially because of the already high savings balances highlighted earlier in this note.

Now you can see why I disagree with the economist quoted in the media story I highlighted earlier and, indeed, with the broader consensus view that the MPC's actions are vital to the UK economy's growth outlook in 2024. They are not.

UK households will, in my judgement, do just fine with or without any assistance from lower interest rates. In the months ahead, I think it will become increasingly clear that growth in consumer spending here in the UK, mirroring what is already happening in the US, will generate broader economic growth well above low consensus expectations. 

Importantly, I am not saying that the cost of money isn’t important to the UK economy in the long run. It is. It is self-evidently true that cuts in official rates can help to boost consumer and business confidence. All I am saying is that, right now, the UK economy doesn’t need lower interest rates to deliver robust growth in 2024 and 2025. 

Of course, the improving economic outlook for the UK economy should have important implications for the UK stock market, especially its lowly valued domestic economy-exposed constituents. But that’s a story for another day – one that I will tackle next week.