- Higher rates haven’t taken as a big a toll on the economy as expected
- Evidence suggests that although monetary policy transmission might have slowed, it hasn’t turned on its head
Today’s combination of high interest rates and buoyant economic performance is a puzzle. Such a puzzle, in fact, that it’s tempting to think something highly unorthodox: could higher interest rates actually be stoking the economy?
The chart below illustrates the path of interest rates in the US and UK over the past 30 years. Although rate hikes have been both rapid and intense, the impact on economic activity has been far more muted. The UK has just exited one of the mildest recessions on record, and the IMF expects the economy to expand by 0.5 per cent over the course of 2024.
In the US, performance has been even more striking. Far from teetering on the brink of a contraction, the economy is expected to grow by 2.7 per cent this year. What if economies aren’t growing in spite of interest rates, but because of them?
Things are different this time
There is no denying that this cycle has been unusual. A look at the chart above reveals that the last time interest rates were this high was before the financial crisis – and a lot has changed since then.
Economists at the Resolution Foundation calculate that since 2007, household indebtedness has fallen as a proportion of income, while savings have soared. Before the financial crisis, the gap between the two measures was 42 percentage points – today, it is just six. This has left households far better positioned to gain from rising rates. According to the analysis, UK households have seen debt interest costs increase by £18bn since rate hikes began, but this has been more than offset by a £34bn interest income boost.
As well as being surprising, it is also unusual. In the 1980s, 1990s and 2000s, rate hikes tended to push up households’ debt repayments by more than any extra income from savings. The economists note that “this income boost is not only unprecedented in recent UK economic history, but internationally, too”.
Fixed-rate mortgage deals have also offered additional protection. In the UK, five-year fixes had replaced shorter fixes as the most popular deal, while the impact is even greater in the US, where 30-year mortgage terms are the norm. Analysis from Capital Economics suggests that while interest rates on new loans rose to 8 per cent in 2023, the rate on outstanding mortgages stayed at 4 per cent for the entire year thanks to the protection offered by long-term fixes. In this cycle, higher rates on savings have filtered through far faster than higher mortgage repayments have.
Higher rates can mean higher business costs
This isn’t the only mechanism. Economists have long talked about a ‘cost channel’ of monetary policy transmission. As interest rates rise, so do firms’ borrowing costs, which can be passed onto consumers in the form of higher prices. This theory seems to have influenced some of Turkey’s more unorthodox policy decisions: president Recep Tayyip Erdoğan said last summer that interest rates have “now been reduced to 8.5 per cent and you’ll see inflation will also fall”.
But research suggests that where there is a ‘cost channel’, it is overwhelmed by transmission mechanisms running in the other direction. Higher interest rates also discourage borrowing, decrease investment and increase savings, all of which work to reduce demand and cool inflationary pressure. Even the Turkish central bank has turned to more conventional interpretations, and has increased the policy rate to 50 per cent.
Transmission looks slow, not upended
There are signs that higher rates are starting to hurt – even in the buoyant US economy. Credit cards and car loans, which operate with floating rates, are showing signals of stress. Credit card delinquency rates have been rising since 2021, and are at the highest rate since 2010 on auto loans. Economists at Dutch bank ING note the divergence between business surveys and official data, and “strongly suspect that business caution will translate into weaker hiring and wage growth and subdued business capex, and that will eventually show up in the official GDP data”.
Economists forecast that the household savings boost will run out of steam, too. The Resolution Foundation expects the extra income to unwind by the end of this year as cheap mortgage deals expire and interest earned on savings falls as rates are cut. Economists note that “ironically, this means that the [Bank of England’s] decision to raise rates between 2021 and 2023 could cause a significant living standards tailwind in 2024, even while the Bank starts to cut interest rates”.
This all points to monetary policy transmission being weaker this cycle – but not turned on its head.
