Where now for interest rates?

Posted on May 16th, 2011 | Categories - Financial News

The past few days has seen renewed press speculation on the future of interest rates, much of which has been caused by the Bank of England’s latest Inflation Report.

If you believe some of the press reports we can expect interest rates to rise significantly and very soon, causing even greater hardship to the UK consumer, especially those whose mortgages are not on fixed rates.

But is this really the case? We thought we would take a more considered view.

What did the Bank of England announce?

Their report talked about strong downward pressures on growth and upward pressures on inflation, caused by higher food prices and fuel bills.

However it is clear that the Bank still believes inflation will fall back towards its 2% target in 2012. Although the Bank’s Governor, Mervyn King (pictured), has changed his position slightly, he now says that inflation  “may not fall back as strong as expected”.

How are inflation and interest rates linked?

High inflation is generally seen as a bad thing, then again so is deflation, so it is something of a tightrope.

It means take home pay stretches less far and potentially causes the economy to overheat.

The mean weapon against rising inflation is higher interest rates. The theory goes that if you increase interest rates, you decrease the amount of money people have to spend as the cost of borrowing money will rise. This in turn means businesses can charge less for goods and services which then reduces inflation.

Are there any other factors that might push interest rates up?

Interest rates are set by the Monetary Policy Committee (MPC) which is made up of nine members each voting for no change, a reduction or an increase.

For more than two years now the committee has voted for no change in rates, however recently the votes have been getting tighter.  Last month three of the nine members voted for an increase, it would only take two more members of the committee to change their minds for us to see higher rates.

What might keep interest rates down?

Lead time. The decisions taken by the MPC now, don’t affect inflation tomorrow; there is a lead time, which could be as much as two years.

In his latest statements Mervyn King suggested that he still believes inflation will fall in 2012 – 13. The question must therefore be asked, why would the MPC increase rates now if inflation is set to fall anyway?

The answer could of course be that the other members of the MPC disagree with Mr King.

Gloomier economic forecasts. In the latest report the Bank of England have downgraded their forecasts for economic growth for 2011 from 2% to 1.75%.

Any rise in interest rates would increase costs for many UK businesses and therefore effect economic growth. The Bank already has a gloomy outlook for economic growth, would they really want to make the situation worse by increasing interest rates?

Wage inflation. Wages in both the public and private sector are rising slowly. Low wage inflation should feed through in time pushing the overall inflation figure down.

Temporary factors. The Bank still seem to believe that the factors pushing up inflation, such as the VAT rise in January, fuel prices and the cost of food are temporary and will slowly become less of a factor. This is certainly the case with the VAT rise which will drop out of the figures early next year. Whilst the Bank and the MPC continue to believe that the causes of inflation are temporary it may decide not to push up interest rates.

There is also an argument that some of the inflationary pressures are beyond our control as they are from overseas, and that any rise in interest rates would have no effect.

Independence. The MPC is independent from government, not the general public. It therefore has some ability to ignore media calls for an interest rate rise and pursue a course it believes is right.

Our view

Mervyn King and the MPC are walking a tightrope and have been doing for some time. On the one hand they have rising inflation which is significantly above their 2% target. Despite Mr King’s statements to the contrary, and with the obvious exception of last month inflation keeps rising, indeed Mr King himself has indicated that he believes CPI will hit 5% this year.

On the other hand interest rates are at an all time low.

The conventional course of action would therefore be to raise interest rates to dampen inflation.

However there is nothing conventional about the times we live in. At this stage of the economic cycle, having come out of recession over a year ago, we would be seeing stronger economic growth, but we aren’t and here lies the problem.

It seems that the MPC sees higher inflation and low interest rates as preferable to increasing rates and potentially damaging the fragile recovery.

However Mr King acknowledged this week that “bank rate will need to rise at some point. It cannot stay at this level indefinitely.”

The big questions though are when, and by how much.

If economic data continues to be mixed our view is that interest rates will stay low into 2012 and possibly into 2013. Any fall in inflation in line with Mr King’s expectations would reinforce this view.

Whilst there may be tweaks upwards during this time if the economy is still weak any rise in interest rates is unlikely to be significant.

If we were placing a bet based on the current situation we wouldn’t expect to see one of these tweaks until late autumn of this year, possibly even later.

We could of course be wrong and a rise may happen sooner, which is why it wouldn’t be a big bet!