A homeowner quirk means we might be able to cut rates

Setting interest rates is a surprisingly abstract process. Rate-setters vote to change the base rate and initially, this applies to only a few financial institutions. Savings accounts and mortgage rates are affected, but changes do not affect everyone immediately. 

Over the next 18-24 months, the new policy rate is passed on to the rest of the economy through a series of 'monetary policy transmission mechanisms’. Soon, total activity levels start to change, feeding through to total demand. This starts to impact domestic inflationary pressure, and, eventually, the inflation rate. That makes for what is at points a rather vague and theoretical process.

But new survey data from the Bank of England (BoE) gives us a gratifyingly concrete insight into how exactly higher interest rates are feeding through. Higher interest rates have led to surging mortgage repayment costs for many homeowners. And for every £100 of additional monthly mortgage payments, households have cut back monthly spending by £50. 

Thanks to the prevalence of fixed-rate mortgage deals, a sizeable proportion of households haven't seen a change in their repayments so far. According to UK Finance, a trade association for the UK banking and financial services sector, at the time interest rates started rising in late 2021, 74 per cent of existing mortgages were on a fixed rate, while almost all new borrowers were electing for fixed-rate deals. And as of December 2023, about 45 per cent of these cheap fixed-rate deals had yet to renew.

As deals expire, millions of households will face substantially higher monthly payments. And rate cuts won't entirely ameliorate the situation: economists do not expect a return to near-zero interest rates any time soon. This means that mortgagors still face the prospect of rolling on to more expensive deals – albeit on rates less painful than the peaks reached last summer. 

According to the BoE’s Financial Stability Report, the average mortgagor moving to a new deal over the next three years will see repayments increase by 39 per cent – about £240. If these households show the same propensity to cut back, we could see spending fall by an average of £120 in response. For some, the squeeze will be far tighter. The BoE estimates that about 100,000 households will see their repayments increase by £1,000 a month or more by the end of the year. 

There is evidence that households on cheap deals are already bracing for impact. The BoE research found that mortgagors who expect an increase in monthly repayments in the future are changing their behaviour today. As the chart shows, for every expected £100 increase in monthly mortgage repayments, households cut spending by £28. 

Even those cushioned by longer-term deals are taking precautionary measures. The research found that 38 per cent of households with fixes ending in 2027 had cut back in preparation for higher repayments, while 46 per cent expected to do so over the course of this year. The fact that households are cutting spending as repayments go up is to be expected. The fact that they are doing so in anticipation of higher repayments well into the future is more surprising.

For much of this tightening cycle, there has been speculation that fixed-rate mortgage deals have ‘clogged up’ monetary policy transmission channels by shielding borrowers from the impact of rate hikes. Yet this data suggests that households are acting to get ahead of higher mortgage repayments coming down the pipeline. The researchers conclude that the overall reduction in spending in response to higher rates is “faster than the speed of the increase in mortgage costs”. In other words, monetary policy might be feeding through more quickly than expected. If so, this strengthens the case for base rate cuts sooner rather than later this year.