[OPE] Interest rates

Careful now: Why even small interest-rates rises could have a big impact on
consumers

The Economist Apr 7th 2011

(...) Analysing the debt and cash holdings of all consumers lumped together
reveals little about the effect of interest-rate increases on spending. That
actually depends on how the aggregate cash hoard and debt burden is divided.
People typically do not have both large debts and piles of cash, since it
would make sense to use the latter to pay off the former. Rather there is a
financial spectrum with, at one end, debt-laden householders, usually young,
who have recently taken on a hefty mortgage and have little spare cash; and
at the other end, older savers who have paid off their mortgages, or who
have traded down to smaller homes and banked the proceeds.
These different sorts of consumers will respond to interest-rate increases
in ways that are unlikely to be neutral for the economy. The indebted will
cut their spending to free up the extra cash to service their loans. Once
rates start to rise, those with the biggest debts might be anxious to save
harder to pay down those debts at a faster pace. At the other financial
pole, the cash-rich and debt-free (by definition savers not spenders) might
well spend little, if any, of the extra income they gain from higher deposit
rates.

Any squeeze on debtors' incomes might be mitigated if banks chose not to
pass on any increase in funding costs stemming from higher base rates. That
scenario is optimistic. The gap or "spread" between the Bank of England's
rate and the average interest rate on mortgages (which account for
four-fifths of household debt) has narrowed a bit recently, though it is
much higher than before the financial crisis. This narrowing owes little, it
seems, to banks competing more vigorously for mortgage business. Rather it
reflects lower rates for borrowers whose fixed-rate deals had expired and
lapsed into cheaper variable-rate mortgages.

In one sense, this is helpful: it has lifted the incomes of some borrowers
at the banks' expense. But it has also made the economy more sensitive to
changes in short-term interest rates. Before the crisis, around half of
mortgages were at variable interest rates; by the end of last year, the
share had risen to 69%. This greater sensitivity is heightened by the
fragile state of Britain's housing market. Higher rates will crimp the
already-weak demand for homes and weigh on house prices-perhaps spurring
anxious borrowers to spend less and pay off their mortgages quickly. (...)

Complete article: http://www.economist.com/node/18530079?story_id=18530079

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Received on Fri Apr 8 19:09:36 2011