What if interest rates were to rise?


Written by Lawrence Zammit, 21 March 2014

Last week the Governor of the Bank of England stated that Interest rates will rise six-fold by 2017 as Britain’s economy becomes one of the fastest growing in the developed world. For the last number of years interest rates have been falling or staying flat, but never rising. Recent statements by the President of the European Central Bank and the Bank of England Governor gave everyone to understand that abnormally low interest rates will be with us for some more time.

In effect interest rates in the in the Euro zone and the United Kingdom have never been so low for so long a time.

However as economic recovery becomes more defined and no longer remains fragile as it has been in recent months, interest rates would be expected to start rising again. They could reach around the 3% level within the next three years.

Such an increase to more normal levels will be welcomed by many savers who have faced record low rates for more than six years. On the other hand it will mean very bad news for many borrowers who may be plunged into financial difficulty. As with most aspects of the economy, when interest rates change, there are winners and there are losers.

The low interest rates of the past years have affected very negatively savers who rely on cash investments (such as savings accounts) for income. The winners in this situation were the borrowers, which have included home buyers, businesses or individuals that have wanted to invest further in increasing the value of their physical assets.

Borrowers have gained further by the fact that banks have tended to extend the period for which they lend money. For example, up to several years ago, a home loan used to have to be repaid within 25 years; nowadays the period is much longer. Another important winner has been public finances as public sector borrowing costs have also decreased.

An increase in interest rate will turn the tables. Savers will be ale to earn more money, even if their earnings will not return to the levels that had been experienced before the international financial crisis. At that time rates of around 5% were considered to be normal, while the new normal rate could be around the 2.5% to 3% level. For borrowers there will be increased costs and the question that needs to be asked is whether such increased costs will be sustainable.

Let us take the example of businesses. With increased competition, several businesses have experienced a severe narrowing of profit margins. They have sought to maintain profit margins by reducing expenditure such as cutting down on discretionary expenditure or putting a tight lid on wage increases. An increase in borrowing costs could render such businesses unsustainable as they have little to no room left for manoeuvring. They cannot increase prices and they cannot reduce their costs any further.

The same could apply to consumers with home loans. Low interest rates and extended periods for loan repayment were two reasons why property prices went up. So the percentage of one’s disposable income that is used by loan repayments is very close to what it used to be when interest rates were higher. Add to that changed consumption patterns, and one recognises that several home buyers have very little discretionary expenditure that they could reduce to pay for the increase in interest rates.

One study has shown that if the ECB rate were to increase to 2.5% with a resultant knock on effect on commercial bank lending rates, the loan repayment for a 100,000 Euros property could rise by as much as 180 euros a month. Several home buyers may not be able to sustain such an increase with their current level of income.

My expectation in such a scenario is that any interest rate increase will need to be very gradual. A large increase in rates (and a rise to just 1% represents four times today’s level in the Euro zone and a doubling of the UK rate) would hurt borrowers immensely and could well cause a decrease in consumption.

I would also expect Central Banks around Europe (including Malta) to analyse thoroughly the impact of an increase in interest rates on the economy and to work with the respective governments to mitigate the downside risks of such an increase. Unless any future increases in interest rates are carefully managed, there could be a return to an economic recession.

 

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