Economists are warning that the UK economy faces a sharp recession and a flood of job losses if interest rates hit the 6% level financial markets believe is on the cards.
Household budgets are under increasing strain again as mortgage costs spike, while rocketing corporate insolvencies suggest firms, particularly the smaller ones that account for the bulk of employment, are struggling to cope with higher borrowing costs.
The UK has so far weathered the cost of living crisis without falling into recession. The growth outlook was even upgraded recently by the International Monetary Fund. But economists now fear the BOE will have no choice but induce a downturn to curtail inflation, which is coming down more slowly than Governor Andrew Bailey and his colleagues expected.
Markets expect another quarter point hike next week to 4.75% and for rates to reach 5.75%, or possibly even 6%, next year. That would be a 22 year high and add £250 ($321) a month to the average mortgage payment, according to the Resolution Foundation – five times more than the saving from the recent drop in energy prices.
Neal Hudson, a property market analyst at BuiltPlace, has calculated that homeowners would be spending almost a quarter of their income on mortgage costs, up from 17% in 2020, with rates at 6%. For those who have to remortgage at the higher rates, or who are on tracker deals, the cost of living crisis will feel more severe than during the energy price shock.
“If the Bank does push rates up as much as markets expect there will be a recession,” said Gerard Lyons, chief economist at wealth manager Netwealth. Erik Britton, chief executive of Fathom Consulting, agreed: “A recession is in the post if rates hit 6%.”
Mortgage borrowers already are hurting from the 12 rate rises the BOE has delivered since 2021, putting the benchmark lending rate at its highest since 2008. That along with jitters in financial markets has driven up the cost of both mortgages and business loans, with both Britton and Rob Wood, chief UK economist at Bank of America Merrill Lynch, saying the corporate sector is near a tipping point.
They fear that a spike in insolvencies will drive up unemployment and trigger a second wave of layoffs as companies that are currently hoarding labor due to worker shortages let people go. Consumer spending would collapse at that point, and a downturn would be inevitable. House prices would crash as people who could no longer meet their mortgage payments turn forced sellers.
Megan Greene, who joins the BOE’s rate-setting committee next month, told Parliament this week that an “abrupt” end to “labor market hoarding … would have significant implications for consumer confidence and for consumption and could prompt a recession.”
As companies released staff they were hanging on to, unemployment would suddenly spike, said Raghuram Rajan, a former International monetary fund chief economist and professor of finance at University of Chicago Booth School of Business.
“Then you have more unemployment than you want, because these things move in a non-linear fashion. Unemployment is terrible for demand and terrible for housing because unemployed workers who can’t make their mortgage payments will sell.”
It’s a gloomy scenario that Britain may well avoid. Most economists think rates will peak below the levels markets have priced in. The current worries among investors were triggered after a jobs market report showed inflationary pressures remained much stronger than expected, and figures due in the next few weeks could well surprise to the downside.
Even so, the outlook puts Prime Minister Rishi Sunak in a tough position ahead of an election widely expected next year. While he shares the BOE’s determination to rein in runaway prices, the bitter medicine of a recession could hurt him at the polls.
Rate rises are almost as much a constraint on what the government can offer to voters as they are on households. The Liberal Democrats have called for a £3 billion mortgage support fund to help distressed borrowers but every percentage point increase in rates adds £20 billion to cost of servicing the government debt. With only £6.5 billion to spare in March, Chancellor Jeremy Hunt has no room to move without blowing up his fiscal rules.
Even without a recession, the BOE estimates the UK’s medium-term growth prospects point to a sputtering expansion of 1% a year, slow enough that living standards will slip behind G-7 nations.
As higher borrowing costs squeeze households, consumer spending will fall and consumer price inflation should decline with it. But Wood said the pass through will be slower than in previous cycles because so many people are on fixed term mortgages these days. He estimates consumer spending will shrink just 0.5%. If the same proportion of borrowers were on floating rates today as in the 2008 financial crash, the impact would be three times worse.
Although many individuals will suffer, the aggregate economic impact only becomes catastrophic if people start losing their jobs consumer demand dries up on a far wider scale, Wood said.
For that reason, Wood and Britton believe the trigger for a recession this time be in the corporate sector. Fathom analysis shows that 12% of publicly listed UK companies are already technically “zombies,” unable to pay interest costs out of earnings. The proportion will double with rates at 6%, Britton said. At that point a quarter of listed businesses would be struggling to survive.
Official government figures Friday showed insolvencies at a new high, up 40% compared with last year. “Interest rates and inflation will continue to create challenges for businesses over the summer, and could be the tipping point for those business hanging in there,” said Nicky Fisher, president of R3, the UK’s insolvency and restructuring trade body.
According to Naresh Aggarwal, associate director at the Association of Corporate Treasurers, businesses with lots of debt, such as those backed by private equity and those in interest-rate sensitive sectors like property, are already struggling to get hold of credit.
“Larger businesses that are in good shape are now much more wary of credit risk across their supply chain,” he added.
Central banks have been trying to strike the perfect balance between tightening financial conditions enough to bring down inflation and going so far that they cause a crash. Persistently high prices and wages keep piling the pressure on the BOE to raise rates further, though, adding to the risk of a “policy error” of doing more harm than necessary, said George Buckley, European economist at Nomura.
In that event, Britton said the BOE would only have itself to blame for not moving against inflation fast enough early last year. “The BOE left it too long and was too vague about what it was trying to achieve,” Britton said. “A deep recession will be seen as a failure.”
