Why interest rates could rise sooner than you think

By Associate Editor David Stevenson Jan 21, 2010

David Stevenson

Share with
friends:

Comments (14) Print this article

It's been a week of ups and downs for the British economy.

The inflation rate zooming up to 2.9% on Tuesday was a nasty shock. Unemployment falling to 7.8% from 7.9% yesterday was a pleasant surprise (though as Merryn Somerset Webb points out on our blogs page: What's good about the employment data?, you shouldn't take this at face value).

Taken together, these two data points have got many people believing that Britain's now out of recession.

We're not so sure. But whether or not the UK economy is - sort of - getting back on track, another risk is growing. Interest - and loan - rates could start rising again sooner than expected.

So what does that mean for you?

Everyone knew that the annual rate of growth in the UK consumer price index (CPI) would rise above the Bank of England's 2% 'target'. Bank boss Mervyn King has been warning about it for ages. And the experts were, on average, going for annual inflation of around 2.6%.

But 2.9% was very much top of the range. If the headline CPI goes over 3%, Mr King has to write to the Chancellor to explain why. And there's a very good chance some Bank stationery will soon be pressed into service. Just this week, the governor said inflation "would be likely to rise over 3% for a while".

However, there's no need to worry. Mr King also reckons this should be temporary. Inflation "should return to target in the medium term". That's when the nasty effects of energy price hikes and VAT returning to 17.5% are supposed to drop out of the calculations.

So that's all right then.

Or maybe it's not - on several counts.

The Bank's forecasting track record is not good

First, the Bank's forecasting track record isn't great. As Edmund Conway points out in The Telegraph, it's generally behind the curve. "Even when you strip away those volatile bits and pieces and look at core inflation, prices are rising faster than anyone expected. According to the Bank's forecasts in early-2009, core inflation ought by now to have dropped beneath 1%. It's now up to 2.8%".

Second, a lot of the inflation damage has been caused by the weak pound. Sterling has undergone its biggest depreciation since Britain left the gold standard in the 1930s. That may have lessened the damage done by the global recession as UK goods have become cheaper to buyers outside the country. But the other major effect is to inflate the price of imported goods.

The fallout takes time to filter through, but now it's working its way into shop prices. Sure, the pound is recovering against the euro right now. But that's mainly because the currency markets are getting spooked about eurozone problems, such as a possible debt default by Greece. It's not because Britain has become a great place to invest once more.

Also, if we're right that the US dollar is about to rally: (Two British stocks to buy as the dollar rebounds), the pound is likely to fall against it. So the cost of imported raw materials priced in dollars, such as oil, could keep rising too.

And don't forget that the Bank has printed almost £200bn of extra pounds over the last year in its 'quantitative easing' programme. That's an awful lot of additional sterling supply. It could eventually depress the value of our currency once more.

Third, the country's dole queues have shrunk. Not a lot, but job losses were expected to continue for many months after the recession ended. If unemployment has already peaked, the economy might be turning up again. And fewer people out of work would mean more disposable income becoming available to pay higher prices. Also, some reckon Britain isn't merely out of recession. Goldman Sachs sees the UK growing faster than both the US and Europe next year.

Special FREE report from MoneyWeek magazine: When will house prices bottom out - and how will you know?

  • Why UK property prices are going to fall 50%
  • When it will be time to get back in and buy up half price property

Once inflation is back, it'll be hard to remove

Now we're not convinced by this argument. We believe 2010 will be tough for retailers and property companies in particular. They rely on consumer spending which will continue to be curbed while bank loans remain hard to come by.

But even this could be bad news for inflation. As Simon Nixon points out in the Wall Street Journal, "with credit still constrained, firms may struggle to find the capital to raise capacity" – i.e. to invest more – "and so will raise prices instead".

Once inflation gets embedded into the system again, it's likely to prove very stubborn to remove. In November, i.e. well before the latest set of figures, respondents to the Bank's Inflation Attitudes Survey already reckoned consumer prices would rise by 2.4% over the next year. If inflation expectations start rising again, those fears could prove more than self-fulfilling.

And that could result in something that borrowers certainly don't want to see. Interest rates could start moving up sooner rather than later.

Let's not forget that the main job of the Bank's Monetary Policy Committee is to keep inflation under control. It's not there to manage economic growth or the government's spending shortfall. And at 0.5%, the Bank's base rate, which sets the tone for home loan and credit card rates, is at by far its lowest-ever level. It's also at its lowest level compared with the inflation rate.

This chart makes the point...

[click on the chart for a larger version]

The red line is the base rate and the blue line shows inflation, both over the last 20 years.

If inflation doesn't drop back again soon, as Conway says: "the case for tightening policy is getting ever stronger". In other words, the Bank will have to raise base rates.

That may not happen on this side of the general election, which is due by 3 June this year. But the next chart flags another warning…

Interest rates could rise sooner than you think

[click on the chart for a larger version]

The yield on ten-year gilts - the blue line - is climbing again. That's because competition for cash is growing. Investors are getting fearful that governments, with their huge budget deficits, will have to pay higher rates to borrow the money they'll need.

Historically, climbing gilt yields have been a clear sign that a rise in the base rate - again the red line - isn't too many months away.

And borrowing costs look set to rise in any case. Look no further than yesterday's decision by the Skipton Building Society to remove the rate guarantee on its standard variable rate home loan. From 1 March the rate jumps from 3.5% to 4.95%. It's a nasty shock for borrowers who thought that low rates were here to stay.

So don't get caught out. Several more home loan deals have appeared on the market recently. In this week's issue of MoneyWeek magazine (out tomorrow - if you're not already a subscriber, you can claim your first three issues free here), my colleague Ruth Jackson (editor of free email, MoneyWeek Saver) takes a look at whether you should switch to a fixed rate. Right now, it could be well worth thinking about.

Our recommended article for today

Venezuela illustrates why you should buy gold

Hugo Chavez's latest economic wheeze carries a stark but important message for savers everywhere, and is an eloquent example of why there's no better insurance than gold, says Dominic Frisby.

Comments (14)

Published in Economics | More articles by David Stevenson

Share with
friends:

Related articles

Comments

Leave a comment

  • 1. Niallw

    (21 January 2010, 11:25AM)  Complain about this comment

    I am not sure inflation is a worry. Sure its risen markedly to 2.9% but for inflation to become entrenched you need wages to rise, banks willing to lend more, borrowers willing to borrow more and this isn't hapenning. Any import price rises in food, oil etc due to sterling falls will act as a tax and force the public to reduce spending elsewhere. Our standard of living will fall, we will save more, spend less on non essential items and have prolongued disinflation or even deflation. With this in mind, should we be buying secure yielding stuff like 10 year treasuries/ gilts with a 3.5 to 4% yield (at leats in the short term), or inv grad corp bond, or strong defensive equities?

  • 2. Niallw

    (21 January 2010, 11:33AM)  Complain about this comment

    Furthermore, the last decade has been a gravy train for public services. The next government will be forced to cut spending so more jobs will go. I would be very suprised if the current recession did not cause unemployment, currently 2.5m to rise above that of the recession in the early 90's, 3m.

  • 3. James Glass

    (21 January 2010, 12:29PM)  Complain about this comment

    very valid points, and probabally correct if you consider an economy with a static supply of money ( i.e. say 1 trillon pounds in the economy, and it stays like that FOREVER), yes inflation would be driven by demand supply... but over longer term inflation is primarially driven by the government printing press
    (especially in soverign countries)

    for example, an average house in 1959 cost about 2 - 3 k... today that house is 150 - 170k.. this rise is certinally not due to a demand supply relationship. now deflation does happen from time to time in actual terms, but the government soon halts numerical deflation with a healthy cash injection..

  • 4. James Glass

    (21 January 2010, 12:53PM)  Complain about this comment

    as a general rule.. the value of money will half every ten years.. eg, house - 1970. 20k, 1980, 40k, 1990, 80k, 2000, 160k.. now its not an exact science by any means. now my numbers are not exact on the house prices its just an example to illustrate a point.

    inflation in the money supply will not put the prices of everything up equally, obviouslly.. stuff that people buy with wages will increase significantly, and suff people borrow money for will increase very slowly. eg bread 7%, house 0.5%, but if overall inflation is 6% and wage growth is 6%... the reason for this is because borrowing money (the cost of which is directally linked to boe base rate and inflation), costs more, and banks are more stringent on lending etc etc

  • 5. James Glass

    (21 January 2010, 12:54PM)  Complain about this comment

    ayway sneeky deflation. accounting for inflation in money supply.

    e.g 500k in a bank, base rate 6%, inflation rate 5.5%, general inflation 5%, inflation adj wage increase 6%. house price increase 0.5%.. and assume this situation for 15 years (or any number of years its irrelevant really given the numbers involved)
    consider following senario, house = 500k
    you have 500k, and want a house.

  • 6. James Glass

    (21 January 2010, 12:55PM)  Complain about this comment

    buy a house now, and that house will cost you 100 percent of your capital on the example.

    500k in a bank at 6% after 10 years = ~ 895k
    500k house after 10 years at 0.5% = 528k

    so you would be spending 58.9 percent of your capital on a house in this example in ten tears.. which, in spending power terms... so although house prices and everything if you look at graphs always go up in value.. in spending power terms in this example this actually deflation, but it won't show up on any price graph.

  • 7. Niallw

    (21 January 2010, 02:00PM)  Complain about this comment

    Hi James, agreed - the govt will want to engineer inflation to reduce the real value of government and the public's debts. In the longer term my guess is we could well see 'price' inflation, especially in food and energy, due in part to sheer money supply and when (in years to come) Asia's reliance on the western markets ends and they compete, without govt stimulus, for commodities as their economies grow. But will we see 'wage' inflation' here in the next few years ? Unlike the 70s we have weak unions and huge competition on the east to contend with i.e. no bargaining power.Also banks are less healthy than many think and still have unrealised bad debt on their books. They won't want to meaningfully increase access to credit for some time.

  • 8. Peter Kellow

    (21 January 2010, 03:27PM)  Complain about this comment

    I would be grateful if Moneyweek could state the number of characters allowed and then ban double posting as most comment columns do.

    James Glass may well have interesting points to make but who is prepared to battle with such ill-formed sentences and bad spelling?

  • 9. Cyclops

    (21 January 2010, 04:29PM)  Complain about this comment

    "Please keep your comment to within 1,000 characters" seems fairly clear.

  • 10. JJ

    (21 January 2010, 05:20PM)  Complain about this comment

    I wonder if the UK uses honest inflation figures.I know,here in the U.S.,that inflation figures are grossly understated.I use the recent UPS and FedEx yearly rate increases of 6% as approximately the real U.S. inflation rate.John Williams' Shadow Stats website also comes up with about that rate.Compare that with govt figures showing under 3%.Eventually, our Fed will raise interest rates,but will keep them well below the real inflation rate.Gold should be an excellent long term holding.

  • 11. John Orrett

    (21 January 2010, 09:27PM)  Complain about this comment

    I think this analysis speak more you your obsession with Liberal Economic thinking and the money supply as driver.
    The world has changed cosiderably since the 1980, which does not mean inflation is gone or boom and bust gone, but is does mean relying upon what happed i the 1970s 1980s to guide decisions is dangerous. This is why you are obsessed with gold, costantly promissing a new correction for the last 12 months which does not materialise and always using the sald old phrase "I am not so sure". Can money weak go a weak without someone saying "I am not so sure". Its capacity to suggest deeper wisdom has long been weakened by your constant overuse of the phrase.

  • 12. John Orrett

    (21 January 2010, 09:34PM)  Complain about this comment

    A good example of relying too much on the past is housing. Your use of a graph of prices from the 80s to prove there will be a correction fails to acknowledge how much has changed.
    In 1970 40% of folk owned their own home. Now it is 80%. This completely changes the dynamic of boom and bust in the housing market. It has not gone away, but will be diffrerent.

    Second, the assumption that first time buyers will disapear due to high prices is wrong, the embeded equity accumulate by owners is used to assist siblings become first time buyers. Those same owners, who are now in the majority are more prepared to sit tight than see their gains fall.

    Finally the generall suspicion of all other asset classes makes housing uniquely attractive. It is an assset you can use which will (eventually) exceed the value of the purchase and have provided you with utility in the meantime. You need to be more balanced and end the daily armagedon end of the world scenarios. You watch to much sci fi.

  • 13. Fly Over

    (22 January 2010, 05:51AM)  Complain about this comment

    Would someone give Peter a tissue to cry in Keep the great conversation coming

  • 14. Billy Bob

    (28 January 2010, 11:56AM)  Complain about this comment

    John Orrett

    The changed dynamic of the housing market !

    The reason 80% of people now own a home is because money was given out with scant regard to the ability of borrowers to pay it back . Building societies like the Halifax, North Rock ,Bradford &Bingley etc went bust from this bad mortgage lending.

    People don’t own their homes at present, they OWE them. They paid over inflated prices due to a market swamped with easy credit.

    When the current 300 year politically low interest rates are forced up, to support future sales of government debt, there will be no embedded equity in property bought during the credit boom.

    ‘These owners are prepared to sit tight’ Yes on their losses while seeing their household income reduced their tax bill raised and at the same time magically supply their siblings with financial support to buy a first property. These siblings of course belonging to the younger age group who are now disproportionately unemployed.

Leave a comment

This will be the name displayed with your comment.

This helps us verify comments are genuine. It will not be displayed anywhere on the site and is stored confidentially.

Please keep your comment within 1,000 characters and relevant to the main topic. We encourage healthy debate, but we don't allow insults or bad language. Anything off topic or unpleasant, we'll remove. Enjoy the conversation! Thank you.

captcha To prevent spam-related comments please enter the characters shown in the 'Captcha' box to the left.

By leaving a comment you accept our terms and conditions.


FREE - MoneyWeek's daily investment emailJohn Stepek

Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.

>