The Bank of England has raised the spectre of a sharp rise in interest rates after deputy governor Sir Jon Cunliffe said that households could withstand borrowing costs as high as 5pc without defaulting on their debts.
A combination of more fixed rate mortgage borrowers, lending caps imposed by the Bank in 2014 and taxpayer support during the cost of living crisis mean that families could cope with rates far higher than the 3pc peak forecast by markets in coming months, Sir Jon said.
It came as Threadneedle Street warned that the economic outlook had “deteriorated materially” and ordered banks to hold back billions of pounds in rainy day funds, restricting their ability to lend to consumers and businesses.
Sir Jon said: “We expect [distress] to rise next year, but we don’t expect it to go back to levels before the financial crisis.”
Asked what level rates would need to hit to push many households into distress and default, he said: “You’d be looking at 5pc to 7pc, or 8pc, on the corporate side. The picture is not that dissimilar on the mortgage market side.”
Four-in-five borrowers are now on fixed rates, compared with just over half five years ago, the Bank said.
Its Financial Policy Committee warned of “tentative signs” of a clampdown by banks on mortgage lending and borrowing by businesses most squeezed by the cost of living crunch and supply chain woes.
The Bank moved to build up banks' emergency reserves by ordering them to increase the countercyclical capital buffer from 1pc to 2pc by next summer, locking up approximately £22bn more in a change that is likely to restrict lending.
The FPC said in its twice-yearly financial stability report that “banks are likely to manage prudently their lending activity” in response to a darkening economic backdrop. But it warned them against an “excessive” credit crunch that would be “counterproductive” by hurting the economy.
The Bank judged that lenders are prepared to cope with the downturn and that tightening lending “to reflect the new risk environment is appropriate”.
Rapid interest rate rises to tame inflation are expected to pile pressure on households and businesses that have borrowed large amounts following the Covid debt binge.
While loans issued under government Covid schemes have low rates and are less exposed, the Bank estimates that 70pc of the current stock of debt taken on by small and medium-sized firms was outside the programmes. It said a “large proportion” is exposed to rapid interest rate rises by the Bank within a year.
The highest inflation in 40 years, climbing borrowing costs and supply chain disruptions will squeeze firms in the hardest hit industries.
The Bank said there will be “some business failures”, particularly in sectors exposed to high energy costs, including manufacturing and transport, and industries vulnerable to a slump in household spending.
“The economic outlook for the UK and globally has deteriorated materially,” the FPC said.
“These higher prices, weaker growth and tighter financing conditions will make it harder for households and businesses to repay or refinance debt. Given this, we expect households and businesses to become more stretched over coming months. They will also be more vulnerable to further shocks.”