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.