European Economics Analyst

UK—Slower Mortgage Drag, Bank Rate To 6% (Moberly)

Table of Contents

Intro
UK—Slower Mortgage Drag, Bank Rate To 6%

7 July 2023 | 3:59PM BST | Research | Economics

Quoted mortgage rates have risen sharply in recent weeks on the back of higher expectations for Bank Rate. The UK stands out as relatively exposed to mortgage refinancing risks compared to the US or Euro Area given short fixation periods. That said, effective rates on the stock of outstanding mortgages are responding more slowly to policy rate changes than in the past because of the shift from floating to fixed-rate mortgages over the last decade.
Our models suggest that the effective rate on outstanding mortgages will rise to 4.6% in 2024Q4 from 2.9% in 2023Q1 (and 2.1% in mid-2021). Based on a reasonable sensitivity of consumption to income, this translates into a meaningful cumulative drag on the level of GDP of 0.6% by the end of 2024, excluding second-round effects. Moreover, just over 50% of this drag is still to come.
That said, our models indicate that if the share of floating rate mortgages were as high as ten years ago, the effective rate would have already risen to almost 5% by 2023Q1 and would exceed 6.5% by 2024Q4. As such, the mortgage affordability channel, which has historically been highly important for UK policy transmission, is operating far more gradually than in previous hiking cycles.
How does this more gradual growth drag affect monetary policy? In a scenario in which inflation appears to be transitory, delayed transmission encourages policymakers to “look through” rises in inflation which are unlikely to persist. However, in an environment in which inflation shows signs of persistence, making it more important to reduce output in the immediate term to prevent inflation becoming entrenched, slower transmission means that a larger adjustment in rates is needed to move output into contractionary territory.
As such, we expect slower transmission to result in a more aggressive response of Bank Rate to signs of inflation persistence. Given the recent indications of persistence in the labour market and inflation data, we now expect a further 25bp hike in November, taking our terminal rate forecast to 6%, and forecast the first cut in 2024Q3.

UK—Slower Mortgage Drag, Bank Rate To 6%

Recent weeks have seen sharp increases in quoted mortgage rates on the back of higher expectations for Bank Rate (Exhibit 1, left). The UK is comparatively vulnerable to mortgage refinancing risks because of (i) high levels of mortgage debt to GDP, and (ii) relatively short fixation periods (Exhibit 1, right). Previous research shows that mortgagors have historically played an important role in monetary policy transmission in the UK, with the consumption response of mortgagors to monetary policy shocks being substantially larger than that of homeowners or renters.

Exhibit 1: The UK Is More Exposed To Refinancing Risks Than The US Or Euro Area...

1. The UK Is More Exposed To Refinancing Risks Than The US Or Euro Area.... Data available on request.

The forecast for quoted mortgage rates is based on the market-implied path for policy rates. Estimates for the breakdown of mortgages by initial fixation put together by the Goldman Sachs Global Economics team.

Source: Goldman Sachs Global Investment Research, Haver Analytics

At the same time, the last decade has seen a shift in the structure of the mortgage market, with a large reduction in the prevalence of floating rate mortgages. These accounted for roughly 70% of the outstanding stock a decade ago, but just 12.5% as of 2023Q1 (Exhibit 2, left). In addition, an increasing number of households with fixed rate mortgages have opted to fix for five years rather than two. This shift means that transmission of higher policy rates to the effective interest rate on the stock of outstanding mortgages is playing out much slower this cycle (Exhibit 2, right).^[1]

Exhibit 2: …But Transmission Is Much Slower Than In The Past

2. …But Transmission Is Much Slower Than In The Past. Data available on request.

Source: Goldman Sachs Global Investment Research, Haver Analytics, ONS

In this Analyst, we review our expectations for how effective interest rates will evolve, how this will feed into consumption, and the implications for the future path of policy rates.

Forecasting Effective Interest Rates

We begin by forecasting the evolution of the effective rate on the stock of outstanding mortgages using a simple model of mortgage resets. Our model now implies that the effective rate on the stock of outstanding mortgages will rise gradually to 4.6% by the end of 2024 as these fixed rate mortgages roll over (Exhibit 3).^[2] However, the rise in effective rates is substantially smaller than would have occurred if floating rate mortgages were as prevalent as ten years ago.

Exhibit 3: Effective Rates On Outstanding Mortgages Are Set To Steadily Increase

3. Effective Rates On Outstanding Mortgages Are Set To Steadily Increase. Data available on request.

Source: Goldman Sachs Global Investment Research, FCA, ONS

Interest and Principal Repayments

We now translate this rise in effective interest rates into an increase in mortgage payments.

Given that the stock of outstanding residential mortgages totals just under £1.7tn, the 2.4pp rise in the effective rate by 2024Q4 would see interest payments rise by £44bn (or 1.6% of GDP). That said, this is likely to be partially offset in the near-term by lower principal repayments; mortgages are structured such that higher interest mortgages have lower initial principal repayments (Exhibit 4, left).^[3]

In addition, principal repayments may decline in the immediate term because of mortgage term lengthening; recent data indicate that the proportion of mortgagors opting for an initial term over 30 years has risen by roughly 10pp. That said, we find that this effect is quantitatively fairly small.

Exhibit 4: Lower Principal Repayments Partially Offset Higher Interest Payments

4. Lower Principal Repayments Partially Offset Higher Interest Payments. Data available on request.

Source: Goldman Sachs Global Investment Research

Considering the offset from lower principal repayments, we expect total mortgage payments to rise by £32bn (or 1.2% of GDP) by 2024Q4.

How Sensitive Is Consumption?

With an estimate for the rise in mortgage payments in hand, we now turn to the drag on consumption.

The drag on consumption is driven by two factors. First, the amount of mortgage debt relative to the size of the economy. The last decade has seen a shift towards outright ownership (Exhibit 5, left). As a result, mortgage debt has fallen relative to GDP and household disposable income (Exhibit 5, right). That points to a slightly smaller drag.

Exhibit 5: Fewer Mortgagors, Less Mortgage Debt

5. Fewer Mortgagors, Less Mortgage Debt. Data available on request.

Source: Goldman Sachs Global Investment Research, Haver Analytics, ONS

Second, the drag depends on the sensitivity of mortgagors consumption decisions to changes in their mortgage repayments. In aggregate, Exhibit 5 (right) shows a meaningful decline in mortgage debt relative to savings, especially during the pandemic, indicative of lower sensitivity if households are more able to smooth their way through shocks. For mortgagors specifically, survey data indicate that interest rate sensitivity likely decreased during the pandemic, and remains below pre-GFC levels despite rising rates (Exhibit 6).

Exhibit 6: Rate Sensitivity Likely Fell During The Pandemic

6. Rate Sensitivity Likely Fell During The Pandemic. Data available on request.

Data for the left-hand side chart is from the Inflation Attitudes Survey, and for the right-hand side chart from the BoE/NMG Survey. No data are available for 2016 or 2022 for the right-hand side chart.

Source: Goldman Sachs Global Investment Research, Bank of England

That said, several factors caution against assuming a lower sensitivity of consumption to income. First, data from the BoE/NMG Survey point to the fraction of mortgagors with low savings rebounding slightly in 2022. Second, the shock to incomes may be longer-lived for those taking out five-year mortgages at these higher rates. Third, the shock will be quite sizeable for many mortgagors given the large change in rates.

Given these factors, we continue to assume a consumption sensitivity of 0.5 as a baseline.^[4] This implies a total drag on GDP of 0.6% by the end of 2024 (Exhibit 7),^[5] excluding second-round effects.^[6]

Exhibit 7: The Drag On Consumption

7. The Drag On Consumption. Data available on request.

Source: Goldman Sachs Global Investment Research

Implications For Monetary Policy?

Our analysis points to a substantial drag in the pipeline from mortgage affordability. Nonetheless, we find that this drag is feeding through much more slowly than in the past. We now examine how this more gradual pass through affects monetary policy.

When inflation is likely to be transitory, delayed transmission encourages policymakers to “look through” shocks that are unlikely to persist. That is because policymakers’ ability to influence inflation in the near-term is limited, and so offsetting the shock would require very considerable interest rate volatility. As such, delayed transmission is likely to lead to a smaller interest rate response to shocks.

If inflation is highly persistent, though, then policymakers have little choice but to attempt to reduce inflation in the near-term to prevent inflationary pressures becoming entrenched. In that case, delayed transmission is likely to lead to a larger rate response to cost-push shocks, since more policy tightening is needed to move output into contractionary territory in the immediate term. Exhibit 8 shows very stylized examples from a simple model to illustrate these ideas.^[7]

Exhibit 8: Slower Transmission Calls For Higher Peak Rates When Inflation Is Persistent

8. Slower Transmission Calls For Higher Peak Rates When Inflation Is Persistent. Data available on request.

Source: Goldman Sachs Global Investment Research

As such, we expect slower transmission to result in a more aggressive response of Bank Rate to signs of inflation persistence. Given the recent indications of persistence in the labour market and inflation data, we now expect a further 25bp hike in November, taking our terminal rate forecast to 6% (from 5.75% previously). We push back our forecast for the first cut to 2024Q3 (from 2024Q2 previously).

James Moberly

1 ^ Although the counterfactual in Exhibit 2 (right) shows a sharp difference in the speed of transmission, it may understate how fast effective rates would have risen if the market structure had not changed in the last decade. This is because it only considers the changing fraction of floating vs. fixed rate mortgages, and not the shift from two-year to five-year fixation periods. On the other hand, we also do not account for shifts in the composition of floating rate mortgages between those on a standard variable rate and those on a base rate tracker mortgage.
2 ^ The ONS estimates imply a slight decrease in the number of mortgages being refixed from 2023Q3 onwards, which could make the rise in effective rates slightly more gradual.
3 ^ Over the longer term this is likely to lead to faster growth in the stock of outstanding mortgages as the principal is repaid slower, which could mean a larger long-run drag from higher interest payments.
4 ^ For a more detailed discussion of this assumption, see our previous analysis of the cash-flow channel.
5 ^ As we have previously noted, one key uncertainty is around the timing of the consumption response to higher mortgage rates. Our model implicitly assumes that each household's consumption falls at the time at which their mortgage rate increases, rather than consumption declining ahead of time. On the one hand, there is evidence that consumption does respond to anticipated income shocks (see e.g. Kueng (2018)). On the other hand, there is some evidence that spending decisions may be affected by news about future income losses (Fuster et al., 2021).
6 ^ In addition, note that these estimates also do not include the effect of higher mortgage rates via the rental market.
7 ^ This model builds on our previous analysis for the Euro Area.

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