When will interest rates rise? Chancellor's austerity now (so we don't pay later) to keep rates on hold - as they stick for seventh year

Updated: 08:17 EST, 17 March 2016

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George Osborne’s continued austerity revealed in his 2016 Budget is likely to keep rates on hold for longer - and his own financial watchdog suggests rates may even fall.

Inflation expectations have been revised down for 2016 to 0.7 per cent, while Brexit uncertainty and slow global growth are also playing on rate-setters’ minds. Meanwhile, the Government has based its economic forecasts on a cut in interest rates from the record low of 0.5 per cent Budget documents showed.

This came the day before the Bank kept rates on hold for seven years in a row. 

The market outlook for interest rates in the February Inflation report

The Office for Budget Responsibility said the outlook for rates in the UK had changed ‘significantly’ in recent months. ‘Our forecast is consistent with Bank rate being reduced below 0.5 per cent for some of the next two years,’ the OBR said in a report published alongside the Budget, yesterday.

Today, the Bank of England's monetary policy committee voted unanimously to hold rates at 0.5 per cent - marking the seventh anniversary of the freeze at rock bottom levels.

Interest rates have been frozen at 0.5 per cent for seven years now in the UK, as the anniversary of the final cut to rock bottom levels passed. Economists have pushed back their forecasts for a rise and the CEBR suggested we should prepare for another whole year of 0.5 per cent rates.

Economist Sam Alderson said: 'Given the outlook for both output and inflation, it looks highly likely that we will see an eighth year of unchanged interest rates. 

While we expect inflation to recover towards 1% later this year, the members of the MPC have plenty of time to watch the supporting factors such as accelerating wage growth and commodity price increases materialise. In the meantime, policymakers can afford to keep monetary policy accommodative, helping to offset some of the downward pressure on the domestic economy.'

The debate over a rate cut 

Recent comments from former Bank of England MPC member Danny Blanchflower added to speculation about a potential interest rate cut recently.

He told the BBC that he believed bank rate would remain at rock-bottom levels until 2021, adding that UK growth is still very weak and the global economy 'feels a little bit like 2008'.

'We cut rates in November 2008 by 150 basis points (1.5 per cent). It was clear that we should have cut by more but didn't because of the panic that it might have caused,' he said.

'It was absolutely clear that this (the financial crisis) was something we had not seen in a generation. We learned that the scale of the shock was enormous.'

Negative interest rates in the eurozone, Japan and Sweden have led to speculation that the Bank of England could cut to below zero, but Governor Mark Carney has indicated this is unlikely.

Yet, a combination of turmoil on global markets, fears over deflation and worries about global growth have pushed back expectations of when rates will eventually rise.

Howard Archer, IHS’s chief UK and European economist, said he expected no interest rate cut but also no rise to come for some time.

‘We doubt that the Bank of England will relax monetary policy given the current strength of the labour market and the likelihood that growth will regain momentum if the June referendum results in a vote to stay in the EU,’ he said.

‘However, we have put back our expectation of the Bank of England raising interest rates from 0.50 per cent to 0.75 per cent to May 2017 from February 2017.

‘We also now only see interest rates reaching 1 per cent at the end of 2017 and 2 per cent at the end of 2018.’ 

Inflation report

The Bank of England held rates, lowered its growth forecasts and its lone policymaker backing a rate rise in recent months dropped his call.

The quarterly inflation report said that outlook for global growth had weakened further since the previous report in November and that the latest data suggest a softer picture for UK activity in 2015 than previously assumed. 

The Bank of England also flagged that ‘wage growth has been weaker than anticipated and labour costs are expected to rise a little less quickly than thought’ in November’s Inflation Report and this was expected to contribute to ‘slower recovery in inflation’. 

It predicted that inflation, which in December stood at 0.2 per cent, would remain below 1 per cent for the rest of the year, although it is forecast to rise to just over 2 per cent in two years' time, as the effects of cheaper energy and other imported goods unwind.

The report said: ‘The central projection for CPI inflation is modestly below that of three months ago for much of the forecast period — reflecting a greater drag from energy prices and a lower path for wage growth, only partly offset by a smaller drag from other import prices — but broadly similar by the end.

‘The risks to the central projection are judged to lie to the downside in the near term, reflecting the possibility of greater persistence in low inflation, but to be broadly balanced further out.'

Howard Archer, chief economist at IHS Global Insight, said it now expected a rate rise at the beginning of 2017, instead of this year, but 'on the assumption that GDP growth has firmed, consumer price inflation is above 1 per cent and gradually trending up, and earnings growth has firmed significantly.'

'We expect the Bank of England to only lift interest rates to 1.25 per cent by end-2017 and 2.25 per cent by end-2018', he said. 

The key charts from the November inflation report 

Interest rate essentials: a quick guide to things you need to know

Slack, wages and forward guidance

Having initially formed its forward guidance on interest rates around unemployment, the Bank of England switched tack when this fell far faster than expected.

It identified the somewhat nebulous concept of slack in the economy as one of the new deciding factors on when rates would be ready to rise.

It is also keeping a keen eye on wage growth and the global economy. 

The Bank’s 2013 August Inflation Report unveiled Forward Guidance Mark 1, which said the bank would not consider raising rates until unemployment fell to 7 per cent or lower. At that point unemployment stood at 7.8 per cent. It promptly dropped like a stone yet rates remained on hold.

Forward Guidance Mark 2 arrived in February 2014. It put slack on the agenda, identifying that spare capacity in the economy meant that it could grow at a faster rate without requiring rates to rise.

The Bank says that some of this slack had been used up, but there had actually been more of it than first thought. 

It is also now looking keenly at wages, which although having risen over the past year at a faster pace than in recent years, remain some way below where they would be expected to be at this point in a recovery. 

Forward guidance: a short history

The UK interest rate outlook underwent a transformation with this initiative from Mark Carney, which was launched alongside his first quarterly inflation report as Bank of England governor.

He pledged that rates will not go up as long as the unemployment rate remained above 7 per cent. 

The Bank initially projected a very slow recovery that would not see it fall below 7 per cent much before late 2016, this was then changed to 2015 as unemployment fell swifter than expected.

Unemployment actually dropped below 7 per cent in January 2014 - by November 2015 it was at 5.1 per cent.

The swift unemployment decline led to a revision of forward guidance, with the unemployment threshold removed and a focus placed on spare capacity in the economy and removing this slack.

Wages also came under the microscope and as inflation fell to zero and below, concerns over deflation raised their head. 

The Bank says interest rates would only rise gradually and even when the economy returns to normal are likely to be substantially below 5 per cent.

QE vs Funding for Lending

Should the economy take another serious turn for the worse, more QE could occur, but it looks highly unlikely. The question now is if and how to unwind it, rather than whether more will arrive.

The Funding for Lending scheme overtook QE in 2012 and 2013. This was designed to allow banks and building societies to take cheap cash from the Bank and pass it on to mortgage borrowers and businesses.

The Bank has since switched off the taps on more funding for mortgages through this, although lenders can still tap into their existing allocation.

The jury is still out on whether Funding for Lending was a winner.

It pushed mortgage rates down substantially, albeit with the best benefits delivered to those with big deposits, but banks are still being accused of hoarding cash and shunning small and medium-sized businesses.

Figures are being skewed by mammoths Lloyds Banking Group and Royal Bank of Scotland winding down their historical loan books and Spanish giant Santander easing back on its former mortgage expansion policy.

One group undeniably hit very hard by Funding for Lending has been savers. Returns on savings accounts have dived since its launch in a race to the bottom that has seen big cuts in the best deals on offer.

The best easy access savings rate now stands below 1.5 per cent, whereas before the launch of Funding for Lending savers could get between 2.5 per cent and 3 per cent.

HOW DO YOU FORECAST FUTURE INTEREST RATE RISES?

We can't - no one can. But we look at overnight swap rates to work out roughly when money markets forecast the Bank Rate will start to rise from the rock-bottom level of 0.5 per cent. 

This is very far from a precise business - not only do financial traders make wrong predictions all the time, but swap rates are only a snapshot of their views at a given moment in time.

Money market forecasts often diverge from reality, as well. For instance, swap markets for some time predicted a cut to 0.25 per cent. However, this was considered most unlikely to happen even though the Bank rate-setters dutifully discussed it every month. Economic experts say that for practical reasons it could curb lending rather than increase it, making it counterproductive as a method of promoting recovery.

The overnight swap rates move substantially. Take a look at the following chart, which appeared in the May 2013 Bank of England inflation report and illustrates interest rate projections in May compared with February. There is almost a two year gap between the outlook just a few months apart.

Please note this chart is used to illustrate market movements and is not the up-to-date outlook for rates. 

Outlook: The Bank of England's May Quarterly Inflation report mapped out the market's expected path for Bank Rate.

Like the Bank of England, we use the overnight index swaps curve to look at what the money markets are predicting for interest rates, and importantly how this is shifting.

Economists also make predictions of when rates will go up, which are often quite different from those signalled by the money markets.

We frequently quote their views here too if they help shed light on the issue for readers.

You can then consider all the available information and make your own best guess on when interest rates will rise.

Swap rates and money markets vs mortgages and savings

When markets move a decent amount - and the move holds - it can affect the pricing of some mortgages and savings accounts. 

When swaps price a rate rise to come sooner, fixed rate savings bonds tend to marginally improve in the weeks that follow. But it also puts pressure on lenders to withdraw the best fixed mortgages. 

As for using swaps as a forecast, we've consistently warned on this round-up that they are extremely volatile and should be treated with caution - they should be used more as a guide of swinging sentiment rather than an actual prediction.

> Read the Council of Mortgage Lenders' guide to swap rates

Important note: Markets, economists and other experts haven't had a great record of making the right calls in recent years.

This is Money has always advocated caution with any sort of prediction (including our own!). There's no guarantee that those who have made correct calls in the past will make them in the future. 

We'd also urge consumers not to gamble with their personal finances when it comes to predicting rate swings.

What decides rates?

The BoE's Monetary Policy Committee meets once a month and sets the bank rate. Its government-set task is to keep inflation to a 2% target (and nowadays also maintain financial stability). So if inflation looks likely to pick up, it raises rates.