How to Redistribute Wealth

by George Hatjoullis

A constant criticism of the Quantitative Easing and low-interest rate policy of the Bank of England has been that it has favoured those with assets. By implication it has favoured those already rich. This is slightly inaccurate as it has primarily favoured those that have been able to acquire assets on a leveraged basis. These people were not necessarily rich when they started out on their leveraged investment. However, the BoE programme has certainly improved their net worth somewhat. These people are of course often house owners.

The corollary of this criticism is that one way of redistributing wealth is to raise interest rates and reverse the QE programme. Wealth distribution is not normally a consideration in setting monetary policy but perhaps it should be. If the redistribution takes cash out of the hands of those with a low marginal propensity to consume and places it in the hands of those with a higher marginal propensity to consume then the net effect may be what the monetary authority desires, albeit from an unconventional transmission process. But then what is monetary policy today if not unconventional.

To be clear, the concern of the Governor of the BoE, that the recent spike in inflation might be just that, a spike, with the long-term prognosis still deflationary, is not without foundation. However, the UK is already experiencing a labour market shock. The Brexit situation is deterring the inward flow of labour in a material way. Whatever the long-term outcome from free movement of labour, an abrupt loss of supply will have a price effect, at least for a while. Wages are set to rise. The rise may not last very long or be large however as, in the physical absence of British alternatives, the response may be to move straight to capital-intensive labour-saving alternatives. Robots appear to be able to pick strawberries and lay bricks. Nevertheless some wage effect is to be expected in the short-term. The conventional case for a rate rise may thus soon look a little better and whatever the spin, looks matter in monetary policy as much as in fashion.

The initial impact of a rate rise will be to hurt those that have leveraged investments and are funding the leverage through floating rate loans and, specifically, base rate trackers. Well, they have been the main gainers so far so redistributing away from this lot is perhaps ‘fair’. Of course, this category may have relatively high net worth (via their home) but may not have particularly high income. Moreover, if they are budgeting on the basis that current base rates will last for ever they might be in for an unpleasant surprise. There will be casualties. People that live so close to the edge in their finances are always vulnerable to change. It is possible to gain some certainty using fixed borrowing rates.

Five year fixed mortgage rates are quite attractive at the moment. Of course to get the best rate you must have a high value to loan ratio, but with so much equity now in property a great many can probably fix for 5 years at the best rates. Interestingly, 5 year rates may be proportionately less affected by a base rate rise than floating or tracker rates. It depends on what the yield curve decides to do and this in turn depends on how far rates are expected to rise and for how long. One should recall that although lenders may offer a 5 year fix they typically fund off floating rates. Unhedged lenders would suffer as rates rise. Of course lenders do hedge using interest rate swaps. If they have fixed rate assets and variable rate liabilities they can convert the liabilities to fixed rate via the swap market (they swap a variable rate stream of liabilities for a fixed rate stream). They make money via charging a higher fixed rate than the one that they can swap into. Swaps are priced off the yield curve so if the curve does not change much nor will swap rates and nor will 5 year fixed rate mortgages. There are a lot of ifs and buts in here but the point is that it is not obvious what will happen to the structure of mortgage rates if base rates rise from here.

So we know some mortgage holders might suffer if base rates rise but the group as a whole has a lot of equity, much of it gained because of the monetary policy regime of the last 8 years. Not all are individual householders. Many are landlords and no one much cares if they suffer do they? Moreover, they can all alleviate the distress somewhat by thinking ahead a fixing their mortgages. The next issue is who gains?

The simple answer is those trying to acquire assets, like a home, or sitting on cash. There appear to be a quite a few of these albeit more in the older age group and redistributing in favour of this group may not be so popular. Wealth is in their home and this may end up funding their care. Despite the spin most of those of pension age have less disposable income than people seem to think. Any extra interest is likely to be spent. Interestingly, even younger savers might spend more if interest rates rise. It means less needs to be saved to meet a specific saving target (like a house deposit). One of the problems is that cash is still the favoured investment for most people and the return on cash has been poor for many years. A rise in the base rate will significantly boost the disposable income of many and thus spending. It is time to redistribute wealth away from those that have gained so much in the last few years and in favour of those that have been left in rented accommodation and/or are cash rich but income poor.