Analysis - Soft UK interest rate take-off could unnerve Britons

By Ana Nicolaci da Costa

LONDON (Reuters) - When British interest rates finally go up for the first time in nearly 10 years, the impact risks unsettling consumers who are driving the economy even if the Bank of England tries to make the take-off as gentle as possible.

Eight years after the start of the financial crisis, many British consumers remain stretched and household debt is high in a country where many are saddled with heavy property mortgages.

With lending rates historically low, household consumption has been recovering and even rose 3.1 percent year-on-year in the second quarter, its biggest annual rise since the fourth quarter of 2007 just before Britain tipped into recession.

Yet even though borrowing costs are seen increasing only slowly, a move by the Bank of England to start raising rates expected next year could still unnerve consumers whose spending accounted for about 60 percent of the British economy last year.

A 2014 survey commissioned by the BoE forecast over half of borrowers would cut spending if rates rose by two percentage points -- the kind of increase it is expected to make over the next two years. Just 10 percent of savers, who would benefit from higher rates, would increase spending, it found.

True, since that survey was conducted, households squeezed by low earnings over several years have had some relief from a plunge in inflation and a pick-up in wage growth.

According to supermarket chain Asda and the Centre for Economics and Business Research, average household income in Britain after tax, bonuses and spending on essential items were up 10.7 percent in August versus a year ago, close to its highest annual increase since 2009 seen in June.

But some business leaders are nervous, especially those in the retail sector targeting middle and low-income families.

"There's no question that when interest rates need to rise, growth in consumer spending will moderate," said Simon Wolfson chief executive of clothing retailer Next.

Britain's auto industry, which has boomed on the back of ultra-cheap credit deals for consumers, also expects an impact.

"If you think about 65-70 percent of cars are bought on (finance), any small change on interest rates is going to have a dramatic effect on the purchase of new cars," said Tony Whitehorn, chief executive of Hyundai UK.

Retail research firm Conlumino found that more people in August expected the economy and their personal finances to worsen over the next six months than to improve, with most seeing interest rates likely to rise.

Research by data analysts Mintel shows even the better-off are wary: saving was the top priority for those with a household income of 50,000 pounds or more over the past three months.

"Once (rates) start going up, there is always a fear they are going to carry on going up," Maureen Hinton, research director at Conlumino, said.

BoE Governor Mark Carney has said the decision to raise rates will come into greater focus around the turn of the year and this week rejected market speculation that the bank will only move on rates once the U.S. Federal Reserve has. The BoE said in August it expects household consumption growth to slow only slightly over the next two years.

EXPOSED

Mindful of the risk of upsetting the recovery, the Bank plans to move only once earnings have picked up and has stressed rates would likely rise slowly from 0.5 percent now to a level still lower than their pre-crisis level around 5 percent.

Yet while household debt has fallen, that debt in 2014 still represented a lofty 136 percent of disposable income -- higher than in the United States, Germany and Spain.

And even though 45.5 percent of outstanding mortgage debt was on fixed rates in the second quarter -- the highest share since late 2007 -- the majority is fixed for only one to five years and the remainder is exposed to immediate rate changes.

Martin Beck of consultancy Oxford Economics said if rates rose to 2 percent by the end of 2018, gross domestic product could be around 1 percent lower than if rates stayed constant, even if wage growth hits 3.5-4 percent by then.

"Because there has been such a long period with unchanged rates, the sentiment shock might be bigger than it would have been in the past when rates were going up and down all the time," he said.

Matthew Whittaker, chief economist at think tank Resolution Foundation, also suggested many Britons were still at risk despite the improvement in real earnings.

Around one-in-seven home owners have difficulty paying their mortgages now, similar to the pre-crisis level of the mid-2000s when rates were significantly higher, the think tank said.

The number of households who spend more than one third of after-tax income on interest could as much as double to around 2 million by 2020 if the BoE raised rates close to 3 percent.

"What you are looking at is not a macro problem...I think we are looking at a minority but a significant minority that could face very acute pressures," Whittaker said.

(Additional Reporting by James Davey, Costas Pitas and David Milliken; Editing by William Schomberg and Mark John)