Last week the UK base interest rate was raised from 0.5% to 0.75%. It is the first time since 2009 that interest rates have been above half a percent. The decision to raise interest rates was unanimous across the nine monetary policy committee members.
Why raise rates now?
The Bank of England (BoE) has been looking to raise interest rates for a while and the move was widely expected. The fact the decision was unanimous could be interpreted as a sign of confidence in the resilience and strength of the UK economy. However, the rate rise still looks curious. Inflation is low, having come off its recent peak, and a rate rise will have little effect because the main driver for inflation at present is the strong oil price. The UK economy is growing but it is not close to overheating and wage growth remains subdued.
I see two reasons for raising rates now. With Brexit negotiations set to intensify when politicians come back from their holidays, this was the only opportunity for the BoE to raise rates and give itself more room to manoeuvre during the next downturn. Second, with the rate rise so widely anticipated, if the BoE had held off it could have caused a significant fall in the pound to fall, driving up the costs of imports and having an undesired inflationary effect.
The rise in interest rates will affect many mortgage borrowers. Those with tracker or variable rate mortgages are likely to be affected right away, they may have already received a notification from their mortgage providers. However, the good news is that the majority of mortgages today are on a fixed rate, particularly those with large outstanding balances, so the announcement will have no immediate impact. But if these borrowers must re-mortgage at the end of their fixed terms then they may have to pay higher rates of interest than today.
Banks tend to push through rate rises on mortgages immediately, but they are usually much slower to pass on the benefits for savers. In addition, savers often do not see the full benefits from a rate rise because banks use the opportunity to widen their net interest margins to boost their profits. While the increase in rates will be welcome news for savers the level of interest earned on cash is still likely to remain low, especially as interest rates are set to rise slowly and are expected to peak at a much lower level.
The interest rate rise was widely anticipated and given it looks like a ‘one and done’ scenario, its effect on financial markets is likely to be minimal. This was reflected in the markets’ reaction to the news.
Stock markets dislike higher interest rates because it makes the returns on equities look less attractive relative to the interest earned on cash, thereby discouraging investors from taking the extra risk of investing in them.
But in the current low interest rate environment, the returns on cash are still incredibly low and once inflation is accounted for, the value of most savings are still falling in real terms. In addition, the rate rise could be seen as a show of confidence in the UK economy and could create more interest in UK-focused stocks.
What’s the outlook from here?
Financial markets have priced in another interest rate rise around this time next year. But between now and then there is the issue of Brexit, which makes any forecasting almost impossible. Should a soft Brexit deal be struck sooner, the BoE will probably have the confidence to raise interest rates before this.
In the longer term, we are unlikely to see the base interest rate rising rapidly or far, most likely peaking at 2-3%. This is because of our ageing population and the effects of the global financial crisis, which led to lower growth and confidence.
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