What's going to happen to interest rates?

by Ed Bowsher on 08 July 2011  |  10 comments
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Interest rates look set to stay low for some time to come.

When inflation is high, policymakers only really have one weapon. They can push up interest rates.

Higher rates encourage ordinary people to borrow less money and spend less too. That means there is less demand in the economy and that eventually leads to lower inflation.  In other words, if people are spending less at the shops, prices tend to rise more slowly.

Inflation currently stands at 4.5%, which is well above the government’s 2% target. In fact, inflation has been well above target for over 18 months now. In normal times, you’d expect the Bank of England to fight back by increasing the base rate. The big banks would then follow suit and increase rates on many mortgages and savings accounts.

But that hasn’t happened so far. In fact, the Bank of England has kept the base rate at a record low of 0.5%, and I suspect we won’t see any change for at least six months.

So why is the Bank of England holding back?

It’s basically because the Bank expects inflation to fall next year even if interest rates don’t rise.

One of the main reasons for that is VAT. A VAT increase in January helped push up inflation but there won’t be any more VAT increases next year. That fact alone should mean that prices start to rise more slowly.

Another big issue is pay. If prices at the shops rise by 10%, you’d normally want your employer to increase your wages by at least 10%. You might even be prepared to go on strike if your employer doesn’t cough up. But if the economy is struggling, there’s a good chance you’ll be worried about your job and you’ll accept a paltry pay rise or no rise at all.

Recent figures show that wages are rising slowly at the moment, so that should feed through to lower inflation next year.

What’s more, the boffins at the Bank of England know that the UK economy is still very weak and they know that a rise in the base rate would only slow down growth even more. Now it’s true that the Bank of England is supposed to only focus on inflation, but, in reality, I reckon it takes other economic factors into account as well.

Given that background, I don’t think the Bank of England will be keen to raise the base rate anytime soon.

Impact

A low base rate is good news for many folk, but sadly not for everyone. The biggest winners are people who have tracker mortgages where the interest rate moves up and down in line with the base rate. They’ll be delighted if the base rate stays at rock bottom rates.

Of course, the big losers are savers who have been receiving rotten returns on their accounts. That’s not going to change. All savers can do is go out and hunt down the best savings accounts that are out there....

Observant readers

Before I finish, I should admit that this article contradicts my last comment on inflation. Observant readers may remember my January blog post:  Interest rate looks ever more likely in which I suggested that a base rate rise by May looked likely. Clearly I got that one wrong....

I said that because I was worried that expectations of higher inflation would become embedded and we’d see higher wage deals. That hasn’t happened. However, in spite of my short-term mistake there, I’m proud of one thing. I’ve never fallen for the widely held belief that Quantitative Easing would lead to inflation soaring above the 10% mark.

Without QE, I’m in no doubt we’d have experienced a deep and prolonged recession, and given the weak state of the economy, it was never likely to trigger away soaraway inflation. So I’m pleased I got that right.