Friday, 21 October 2016

When will interest rates go up?

Plenty of people are wondering what might happen to interest rates - and hence the cost of borrowing and returns for long-suffering savers - if inflation really does pick up to the extent that some economists fear.

There are forecasts of 3% or even 3.5% inflation by the end of next year, up from 1% now. Higher inflation usually means higher interest rates.

However, the normal rules may not apply this time. The Bank of England, which controls interest rates in the UK, may keep them ultra-low.

Why the connection between inflation and interest rates? In the past rising inflation has been seen as a danger sign, of a country which can't pay its way or an overheating economy. Central banks have used higher interest rates as a tool to cool things down.

Here, the Bank of England has been using very low rates to make borrowing cheap and try to warm the economy up.

And across the world interest rates have been used as a sort of shield to defend a currency against a battering in the financial markets. The thinking is that investors might be more willing to buy your currency if you offer a better return in the form of a higher interest rate.

The story so far is that the pound has fallen by 18%, with a likely knock-on effect on prices for the goods we import, including food, clothing and electronic gadgets. So how will this play out?

Here are two scenarios: the "sterling crisis" and "low rates, whatever".

Plenty of newspapers have described what we have seen in the past few weeks as a sterling crisis. But it isn't really. Because, although the pound has fallen sharply, there has been no feeling of desperation about how to rescue it or prop it up.

Some welcome the drop as a way of helping exporters. It makes their goods cheaper for foreign buyers. The Bank of England has let it happen, partly for the same reason, partly because inflation is still well below the national target of 2%. The Bank governor, Mark Carney, has even said he would be willing to see inflation rise higher and still keep Bank rate low. It's currently 0.25%.

That doesn't mean that a sterling crisis might not occur at some point, in which worries about Brexit cause a much steeper fall, threatening much higher inflation. Or in which the public finances deteriorate, or the shortfall on our trade with the rest of the world gets dramatically worse.

Currency experts don't buy this crisis scenario at the moment, though many do see the pound drifting lower.

For what it's worth, anyone who has lived through a foreign exchange storm in a South American country will recognise what happens. Economic problem - currency falls - central banks pretend it's not happening - currency disappears through cracks in floor - central bank raises interest rates sharply - recession - country forced to live within its means.

The low rates whatever scenario features inflation rising but the Bank of England sitting on its hands, possibly after shaving a tiny bit off Bank Rate again early next year.

The thinking behind this is that the Bank can tolerate above target inflation, keeping rates low to support the economy and jobs through the Brexit uncertainty.

If there is anything that the last few years have taught us about the Bank's thinking, it is that its Monetary Policy Committee, the MPC, watches wage increases very closely as a long-term indicator of the inflationary trend.

Wages are increasing, but not very fast and it is hard to see them taking off while employers shift nervously from foot to foot, watching the course of Brexit.

Another factor is today's news that public borrowing is coming down slower than hoped. So it would be harder for the new chancellor, Philip Hammond, to ease off on taxes in some way to give the economy a boost. So reliance on the Bank keeping interest rates low will continue. 

If interest rates are going to stay low, how will that affect your finances?

If you are starting a mortgage or re-mortgaging, you want to be on the lowest rate, obviously. But you might think carefully before paying a big arrangement fee for a short term fix.

Savers need to hunker down for a longer period of low returns. Tempting interest rates on current accounts, like Santander's, are being cut already.

Gas bills. We're at the mercy of the markets here: the pound and wholesale energy prices, which are in dollars.

Spending. Prices of imported items like cookers and dishwashers are already rising by 5-10%. If the pound doesn't recover, expect more increases.

Holidays. Cheaper at home.

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