“High interest rates will help the young”- really?

 

A report out today from the Resolution Foundation finds a dramatic turnaround in working people’s prospects of getting rich

Over the past four decades, the total value of wealth owned by UK households has been on a seemingly-relentless upward path: rising from around three-times GDP in the mid 1980s to almost eight-times.  The key driver of this rise in wealth has been falling interest rates and the associated increase in asset prices. But the cost of living crisis has thrown this upward march into reverse as interest have risen sharply in response to the highest inflation in 40 years.

Their report explores the impact of both changes in households’ active saving behaviour, as well as ‘passive’ moves driven by the sudden end to ultra-low interest rates, on the composition and distribution of household wealth.

Here are its key findings

  • Household saving has whipsawed over the past three years. The adjusted saving ratio peaked during the pandemic at 24.4 per cent – the highest on record. Saving has declined since but remains above its pre-pandemic level.

  • Saving behaviour has direct implications for household wealth holdings, but the fluctuations in interest rates have had a more profound impact: the pandemic saw interest rates hit record lows and asset prices boom which pushed the value of wealth to a peak of 840 per cent of GDP in early 2021.

  • The cost of living crisis, coupled with the monetary policy response, has put an end to the trend of rising wealth. The report estimates suggest that the wealth-to-GDP ratio fell to around 650 per cent by early 2023. This is by far the biggest fall on record as a proportion of GDP, wiping out £2.1 trillion of household net worth in cash terms.

  • A higher-rates world and an ultra-low rates world represent starkly different societies to live in. If the rise in long-term interest rates persists, would could see household wealth settling at around 550 per cent of GDP, a level last seen in 2007. But, if downward pressure on long-term interest rates resumes, this could see wealth settling at around ten-times GDP.

But while those with wealth may see their wealth diminish, the report suggests that the young will benefit from higher interest rates

  • A higher-rates world would  improve housing affordability, helping young, would-be homeowners. Based on current interest rates, the house-price-to-earnings ratio could fall to around 5.6 – the lowest level seen since 2000. But if ultra-low rates return, there would be further upward pressure on house prices, with our modelling suggesting that they could reach 11 times earnings.

The report is right to link mortgage affordability to house prices. If the value of our housing stock falls, young people will find it easier to buy houses, but that doesn’t mean they will get rich from housing, it means that they will pay more for borrowing – making the advantage of owning over renting less. It does not mean they will have more to save for their future, nor does it guarantee them a house that becomes a pension.

The report concludes

  • The future path of long-term interest rates matters hugely in the context of intergenerational inequality. Higher rates of return make it significantly easier to save for retirement. Pre-pandemic, a 40-year-old with median earnings needed to save approximately 16 per cent of their gross income (just over £5,000 a year) to reach a retirement target replacement rate of two-thirds of gross earnings. However, with current rates of return, the required contribution rate for the same goal is much lower at 9 per cent (£3,000 per year).

This is wrong. It is economist talk and  depends on the old “money-purchase” equation where the cost of a pension falls as interest rates rise. This equation was broken by pension freedoms, now income in retirement is based on the balance of the savings pot, typically dependent on equity returns.

The amount people get from a pension tomorrow will be a function of how much they put in and investment growth. High interest rates hurt people’s retirement prospects in two ways, firstly they reduce people’s capacity to save, housing costs squeeze pension saving. Secondly, high interest rates, leading to high inflation, leads to a higher drawdown on pots , leading either to pots running out, or the buying power of pensions decreasing.

What Resolution’s “Peaked Interest” report should be telling us is that sustained high inflation does no-one any good. The target inflation/interest rate of 2% is there for a good reason, it means that debt is cheap to service and households find it easy to save.

But it is telling us the opposite, it’s saying that households can prosper from persistent high inflation and interest rates. It bases all this on the cost of housing.

A short term correction in house prices is probably a good thing, expectations that house prices will grow much faster than inflation encourages ambitious levels of borrowing and the expectation that housing wealth will pay retirement bills. This expectation has been met over the past four decades but there is no fundamental rule that says that getting on the housing ladder secures financial security.

Financial security is created by hard work, entrepreneurial endeavour and by a degree of frugality. You may be able to skip one , but unless you are the beneficiary of a wealth transfer (lottery/inheritances etc) you’re gong to need to save. The era of speculation on house price rises may happily be over. Speculation on crypto and other short-cuts to wealth is equally misguided but will continue so long as “easy money” is the mantra. There is no easy money – drug dealers end up in jail.

Sustained high interest rates help nobody, anyone who lived through the 70s and 80s knows the misery they bring.

In economic terms, the nation gets richer through higher productivity, productive investment and a willingness to forego present pleasure an an insurance against future calamity. The best way of returning to a low inflation, high-prosperity continuum is for us to get back to good old fashioned work!

 

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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