Rising Interest Rates

Interest rates in the UK have started to move sharply upwards. Until 16 December 2021, the Bank of England’s Base Rate was 0.1%. By early August 2022, after six consecutive increases, it was 1.75%. Across the Atlantic, over the same period, the USA central bank, the Federal Reserve, moved its main target rate range four times, from 0%-0.25% to 2.25%-2.50%.

Source: Bank Of England

The Bank of England made it seven from seven at the last meeting this month increasing rates to 2.25% while the Fed made it five from five with a jumbo rate rise of 0.75% to bring its range to 3%-3.25%.

Why are interest rates rising so fast?

There is a one-word explanation as to why the Bank of England and its counterparts around much of the world are raising interest rates: inflation.

In the UK, CPI inflation reached 10.1% in July 2022; a year earlier it had been 2.0%, which just happens to be the Bank’s central target. In the US the corresponding figures were 5.4% and 8.5%, while in the Eurozone they were 2.2% and 8.9%.

Those jumps in the rate of inflation caught the central banks by surprise.

At first the Bank of England, like its US and European counterparts, thought that the higher inflation would be ‘transitory’, a result of the supply chain difficulties that came with the end of COVID-19 restrictions.

By the end of 2021 it became clear that waiting for the transitory spike to disappear was the wrong strategy and talk turned to interest rate increases, with the Bank of England making its first move just before Christmas.

The mistaken belief in transitory inflation explains why rates are now rising so rapidly. Had the central banks made the right call in summer 2021, they would have started pushing up rates back then. Now they are, to use a well-worn phrase of the economic commentariat, behind the curve. That means larger than normal rates increases are now needed to regain lost ground.

How high will rates go?

While rates may will be “rising sharply”, they are still well below the average over the last 50 years where we have seen rates peak at 17% in November 1979.

Source: Bank Of England

The Bank of England is avoiding any forward guidance on rates, preferring to adopt a common central bank mantra that it will be guided by the data. In part that is down to experience when guidance had to be abandoned when events did not unfold as expected.

Although the Bank is not offering any forecasts, in August the money market’s view was that the base rate will peak at 3% around the end of the year and then decline by 0.5% over the next two years.

Whether or not the Bank thinks that picture is correct, it uses those market numbers as assumptions for its economic projections. At first sight 3% looks like a low peak, especially when The Bank of England forecasts that inflation will reach over 13% in the final quarter of 2022.

However, economists are generally agreed that, after more than a decade of near-zero rates, the days of double-digit rates have long since passed. A further factor is that the Bank’s central projection is that inflation will fall sharply after 2023 and be back at 2% in two years’ time.

How higher interest rates affect your finances

The Bank of England’s action is focused on short term interest rates, but longer-term interest rates have also risen. For example, the benchmark ten-year UK Government bond offered a return of 0.97% at the end of 2021. By early August 2022, the same bond had seen its price fall to the point where the yield was just over 2%. Rising interest rates at all terms have several effects:

• The most obvious is that mortgage rates are rising. If you have a fixed rate mortgage, like five out of six borrowers, you will be unaffected until your fixed rate expires. As most fixed rate mortgages have terms of two and five years, one estimate is that, within the next two years, about 40% of borrowers will have to replace their fixed rate loan, probably at a higher rate, or fall back on their lender’s standard variable rate (SVR). SVRs have already followed the base rate upwards – for example, Halifax’s SVR is now 5.24%.

• Deposit rates are rising, with the best instant access accounts now paying around the current base rate. Unfortunately, many deposit takers have seen the higher rates as an opportunity to increase their profit margins. You can still find High Street names offering a miniscule 0.01% on easy access deposits of less than £50,000 (and only 0.1% above). National Savings and Investments have increased their rates, but they remain relatively unattractive – for example, the once highly popular Income Bond now pays 1.2%, 1.05% below the base rate.

• Higher interest rates are not a reason to increase the amount you hold on deposit. The hard truth is that, at a time of high and rising inflation, deposits are a guaranteed way to lose buying power.

• The rise in long-term rates has led to a marked increase in annuity rates, which are underpinned by long term fixed interest securities. The mathematics of annuities means that the increases have been significant. For example, based on a 65-year old, today’s rates are nearly a third higher than those available early last year.

Comment

Increasing interest rates are supposed to keep prices in check based on the assumption that when rates rise, consumers would rather save than spend. There are two issues with that.

The first is that if banks don't actually pass on the full increase (as we have seen with NS&I above) what actual incentive is there to save.

The second, and perhaps the biggest reason the blunt tool of increasing rates wont work, is best evidenced if we split the population into two. Those who can't save and those who can. NB group one are far larger than group two.

Those who can't save, must continue to spend on energy and food, the two biggest drivers of inflation.

Those who can save, wait for it, are already saving. They have far too much in cash already and have grudgingly accepted low rates for many years. This group of consumers may well cut back on spending, but this will be on luxury goods and discretionary spending, which will have altogether different repercussions for the economy.

Raising rates can have a secondary effect in protecting your currency; higher deposit returns may tempt investors to hold Sterling. We have seen today how that is working it with GBP getting close to parity with the USD, a record low.

The two sharper tools for tackling inflation are Quantitative Easing (QE) and Quantitative Tightening (QT).

QE would possibly help most but the Bank of England recently announced £80bn of QT so this would require an immediate turnaround.

On the other hand, a new round of QE is contradictory to the Government's new Growth Plan which has gone down like the proverbial lead balloon with markets.

Looking over the much longer term below, very high rates are the exception rather than the rule.

Source: CC BY-SA 4.0

Worryingly though, that exception was also a period of sustained high inflation, so unless we manage to get rising prices under control, or Central Banks come up with a different solution, expect interest rates to continue rising.

It may therefore be prudent not to rely on the forecasts of Government economists, where preventing panic is a more desirable outcome than being correct.