Currency outlook

Between November, 2003, and August, 2004, UK interest rates rose by 1.25 percentage points from 3.5% to 4.75%. By historical standards the move was modest and the level of interest rates was still low.

The central bank, it was claimed, was simply in the process of removing 'accommodative' monetary policy. Yet consumer spending and the housing market responded. It may not have developed into the hard landing some had feared but the adjustment was, nevertheless, sharp.

Within a year growth in consumer spending had slowed considerably, while the housing market also felt the chill. That swift response persuaded the Monetary Policy Committee (MPC) to 'pause' and eventually cut interest rates. Although the MPC raised interest rates by 1.25 percentage points in 2003-04, only part of that rise was actually passed from the banking system to the private sector. Recently the MPC has been hiking up interest rates.

If the banking sector fully passes these rises on, and the evidence so far is that it will, then the rate tightening faced by households will be almost identical to that which triggered the consumer slowdown in 2003-04.

The bigger differences between now and then are that the level of interest rates is currently higher and the stock of debt held by households is larger than in 2004. Indeed, the stock of household debt is over 15% higher than in the third quarter of 2004, the end of the rate hiking cycle.

Arguably, the 2004 episode showed that the consumer had become more sensitive to small changes in interest rates than in the past. Interest rates no longer needed to rise to double-digit levels to generate a substantial household response, as it did in the early 1990s. The reason is that the higher level of debt held by households meant the repayment of the principal loan is now a much more substantial part of the debt servicing burden.

Crucially, the interest rate rises in 2004 were delivered against a background in which unemployment was falling and households' purchasing power was high. That is no longer the case. For the first time in 20 years households may have to confront rising unemployment as well as rising interest rates. The bad news for households is not limited to unemployment and interest rates - households' spending power has also been severely eroded. Post-tax income growth may be similar now as in 2003 and early 2004, averaging around 4% a year.

One major difference, however, is that the cost of a number of non-discretionary items - especially utility bills - and the continued burden of household debt are now considerably higher.

In recent years households had made use of alternative forms of finance, namely consumer credit and mortgage equity withdrawal to offset any shortfall in income. To a large extent borrowing has underpinned consumer spending and 'compensated' for a slowdown in income growth.

In 2005, for instance, this form of finance added £53 billion to discretionary income, thus boosting households' spending power by 9%. Can that form of finance be sustained, especially if financial markets are correct and interest rates move higher?

Net consumer credit is already on a steady downward trend, and assuming that mortgage equity withdrawal returns to its long-run average, household discretionary spending power growth will be dramatically cut in 2007.

Therefore, if discretionary income is being squeezed and the appetite for credit is waning, the only means to finance consumer spending would be through running down savings. However, even that looks less likely.

Over time there has been a relatively close relationship between the wealth-to-income and saving ratios. As households feel richer they tend to save less. However, over the past year that link between asset prices, wealth and savings has broken.

The bottom line is that households seem to be intent on saving more and the rise in house prices has not changed that.

During the past 10 years, when inflation was persistently below the target, the MPC was the consumer and housing market's best friend, as the Committee sought to encourage domestic spending.

With inflation now above target and likely to remain so, and with the central bank increasingly worried about the prospect of a worsening trade-off between growth and inflation, boosting GDP growth is no longer such a palatable tactic.

In 2003 and 2004 the consumer and housing market slowed sharply in response to interest rate rises, despite a background in which unemployment and savings were falling and spending power was high. If the risk of a consumer hard landing was high back then, it should be even greater now.

Current interest rate rises are happening in a background in which unemployment is now trending higher, household spending power has been dramatically reduced and savings are now rising. Surely the consumer outlook has worsened.

With a renewed interest rate hikes risk hitting households when they are more vulnerable than before, that must increase the probability of a hard landing in 2007. If the probability of a sharp consumer slowdown has increased, the risk must be greater that near-term rate hikes designed to reduce inflation today are replaced by cuts in 2007 designed to help stabilise a weakening consumer market and disinflation.

The slowdown in the US will be mirrored by a similar situation in the UK. The UK will cut interest rates next year while the US Federal Reserve will cut more than expected. This should leave the sterling-US dollar exchange rate in a relatively benign state. Sterling will still fall but that fall will be felt against its biggest trading partner - the euro.

This report was compiled by Peter Calleya, manager, Corporate Strategy & Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.