What next for interest rates? Bank of England raises base rate back to 0.5%
- LATEST ON INTEREST RATES FROM OUR REGULARLY UPDATED ROUND-UP
The Bank of England finally raised interest rates today, more than a decade after the last upward move.
The rise to 0.5 per cent came as the Bank sought to dampen inflation, but is controversial as it could slow the economy.
The key question now is how quickly base rate is lifted beyond this and the Inflation Report mapped out an expected path that with rates at 0.7 per cent at the end of next year, 1 per cent in 2019 and then sticking there through 2020.
The Bank of England raised interest rates today and laid out how it sees them continuing to rise
If inflation falls away as predicted, then that route map could remain intact, but if it stays stubbornly high, faster rises may be needed. On the flip side, recession or a downward turn for the economy would slow things down.
Analysts and economists were divided on the merit of today’s base rate hike. Some see little as having changed to warrant a shift from a 7 to 2 vote to hold rates to a 7 to 2 vote to raise them, others comment that this merely takes us back to pre-Brexit vote levels and the Bank had to be seen to take action.
Howard Cunningham, fixed income portfolio manager at Newton IM, said: Given the explicit guidance at the prior meeting, the market had largely priced in today’s increase but questions remain: Is it just a November gesture, or will it develop into something more substantial in the months ahead, with further rate increases in 2018?
'Also, will growth be so disappointing that it will look like an embarrassing mistake, and need to be shaved back off at the first opportunity?
'In our view, it is a worthy move, and it is appropriate to reverse the emergency rate cut put in place in August 2016, both to allay any complacency that rates will never go up, and also to signal that too much inflation will not be tolerated.
'However, I am less convinced that further tightening is imminent, and anticipate that inflation should begin to decline, with the possibility that Brexit uncertainty may weigh on economic activity.'
Alongside the interest rate decision, came predictions for GDP growth, inflation and unemployment
Today's interest rate rise was widely expected after signals at the last MPC meeting and the Bank of England doing little to dispel the belief that rates would go up.
In fact, had rates not gone up today, the bank would have lost credibility in many quarters.
Some do not believe that more rises are wise, however.
Matthew Brittain, investment analyst at Sanlam said: 'We don’t think this is the start of a series of rate increases. Indeed, we believe inflation will return to target levels of its own volition, as the effects of a weak Sterling dissipate.
'The UK remains in a precarious economic position with high levels of consumer debt and the Brexit negotiations delaying investment decisions, so we think that low interest rates are helpful in keeping the economy strong.
'Assuming the inflation outlook stabilises, we think this is the first, and last, interest rate hike we will see for a while.'
Some have also warned that there are other factors that need to be taken into account alongside rates, including the successor to Funding for Lending that pumped cheap money to banks and allowed mortgage rates to be slashed.
Chris Darbyshire, chief investment officer, 7IM said: 'The Bank of England has raised base rates, but that’s not the full story. The monetary stimulus put in place following the referendum comprised the base rate cut, a reduction in the ‘countercyclical capital buffer’ rate, plus the Term Funding Scheme (scheduled to terminate in February).
'It was the combination of these three actions that produced the formidable boost to bank lending following the referendum, and it was the willingness of consumers to borrow that has powered the economy over the past year.
'With defaults in unsecured lending ticking up, however, the Bank of England has decided to start taking away the punchbowl. While these changes will impact relatively gradually throughout the year, they represent new headwinds. The question is whether the strong economic momentum seen outside the UK can carry across the English Channel, or whether the British economy will suffer another year of lacklustre growth.'
What happened with the rate rise?
The Monetary Policy Committee voted by 7 to 2 to raise base rate from 0.25 per cent to 0.5 per cent.
So why has the Bank raised rates now?
The most recent consumer prices index inflation figure was 3 per cent for September and the rise in the cost of living has been running above the target level of 2 per cent for most of this year.
Much of the inflationary effect seen this year has been imported, due to the fall in the value of the pound since the Brexit vote. As long as the pound doesn’t take another major tumble, inflation is expected to peak soon at about 3.2 per cent and then tail off.
Raising interest rates will make little difference in this scenario, but the Bank has taken the decision to move and be seen to be doing something about inflation.
Bank Governor Mark Carney had been hinting a rate rise was imminent.
How high will rates go?
The Bank of England Governor Mark Carney has offered many reassurances over the years that rate rises would be slow and well signalled.
Any diversion from that path is likely to spook borrowers, businesses and the markets.
The inflation report looked as far out as 2020 and then stopped. At that point it suggested base rate at 1 per cent. The new ‘normal’ for interest rates in this cycle has been judged to be about 2 per cent, whether they get there before a recession remains to be seen.
Will inflation tail off?
The inflation that Britain has seen in recent times has been largely driven by shifts in the pound.
We import a lot of goods, food and even essential services such as energy. Petrol prices are also driven by what happens to oil, which is priced in US dollars.
When the pound falls, inflation goes up – and if the pound rises, inflation should go down.
The pound took a big fall against both the US dollar and euro after the Brexit vote, and this ultimately fed through to prices rising for British consumers.
The CPI rise is expected to peak perhaps as early as October, at just above 3 per cent.
Inflation should then tail off and an interest rate rise will bolster the pound and contribute to that.
WHAT DID THE BANK OF ENGLAND SAY WHEN IT CUT?
Laying out its interest rate decision in August 2016, the Bank of England said the following, Simon Lambert explains what it means.
On lower interest rates
BoE: 'The cut in Bank Rate will lower borrowing costs for households and businesses. However, as interest rates are close to zero, it is likely to be difficult for some banks and building societies to reduce deposit rates much further, which in turn might limit their ability to cut their lending rates.'
Translation: We are cutting rates because lower costs will encourage households and businesses to borrow more, encouraging banks to create more money for loans and keep money flowing into the economy. As rates are so low, the effect may be limited.
On its new Term Funding Scheme (which looks like Funding for Lending 2)
BoE: 'In order to mitigate this, the MPC is launching a Term Funding Scheme (TFS) that will provide funding for banks at interest rates close to Bank Rate.
'This monetary policy action should help reinforce the transmission of the reduction in Bank Rate to the real economy to ensure that households and firms benefit from the MPC’s actions.
'In addition, the TFS provides participants with a cost effective source of funding to support additional lending to the real economy, providing insurance against the risk that conditions tighten in bank funding markets. '
Translation: To encourage banks to lend more we will supply them with ultra-cheap funds, which they can pass on to businesses, homeowners and individuals. This worked with Funding for Lending and we think it will work again.
On £60bn more QE
BoE: 'The expansion of the Bank of England’s asset purchase programme for UK government bonds will impart monetary stimulus by lowering the yields on securities that are used to determine the cost of borrowing for households and businesses.
'It is also likely to trigger portfolio rebalancing into riskier assets by current holders of government bonds, further enhancing the supply of credit to the broader economy. '
Translation: By buying government bonds from financial institutions we will drive up the price of gilts and push down their yields, which heavily influence rates on mortgages and other loans. By paying financial institutions for safe haven government bonds we give them money that we hope will be invested in more risky assets, such as company bonds and shares and encourage borrowing and lending.
On buying up to £10bn of corporate bonds
BoE: 'Purchases of corporate bonds could provide somewhat more stimulus than the same amount of gilt purchases. In particular, given that corporate bonds are higher-yielding instruments than government bonds, investors selling corporate debt to the Bank could be more likely to invest the money received in other corporate assets than those selling gilts.
'In addition, by increasing demand in secondary markets, purchases by the Bank could reduce liquidity premia; and such purchases could stimulate issuance in sterling corporate bond markets.'
Translation: We know that the trickle down effect of buying government bonds is disputed, so by also buying corporate bonds we hope to push some money into the system quicker, as those we buy them from are more likely to invest in things that will help the real economy.'
Interest rate essentials: a quick guide to things you need to know
Slack, wages, forward guidance and Brexit, a potted history
Having initially formed its forward guidance on interest rates around unemployment, the Bank of England switched tack when this fell far faster than expected.
The UK interest rate outlook underwent a transformation with this initiative from Mark Carney in summer 2013, 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 and by June 2016 it was 4.9 per cent.
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 now also looks keenly at wages, which although having risen 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.
Brexit added an extra element to all of this, however, and led to an emergency rate cut rather than the expected hike. There is now little forward guidance on where rates are headed beyond the usual pronouncements. The Bank says the next move could be up, or down.
QE vs Funding for Lending
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 later switched off the taps on more funding for mortgages through this, although lenders could 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 were skewedby 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.
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.
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.
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.
ONE WE GOT RIGHT: THE TIP FOR 2014 ON LOW INFLATION AND RATES
Forget unemployment or the property market, it may actually end up being inflation that guides rates – low inflation that is.
Britain may suffer from a persistent inflation problem but it might be easing for now. And the US, Europe and Japan are all more worried about deflation than inflation.
With wages falling in real terms and cheap mortgage cash through Funding for Lending being cut, the Bank may decide the medicine of low rates needs to be prescribed for longer.
The Bank’s move to hack back at Funding for Lending for mortgages has made it clear that switching off the cheap money being pumped into the economy is a higher priority than raising interest rates.
The fear has always been that all this cheap money will send inflation soaring above 5 per cent and then it will stick there. But while property prices and the stock market have certainly done well off the back of it, that hasn’t happened in the overall economy.
There is a chance we will manage to see a better than expected recovery and low inflation at the same time.
Companies grateful for the end of the consumer recession can make more money from simply selling more stuff to more people - and may feel less pressure to raise prices than in a normal strong upturn.
An end to rising energy costs will take the heat off businesses, while a stronger pound will reverse imported inflation.
Meanwhile, very slow wage increases in the past will make even a 2 per cent pay offer look reasonable for many and slack in the employment market may discourage workers from demanding more money or companies from having to pay it.
The Bank of England is looking for any possible reason to keep rates lower for longer. Low inflation might just be it.
- Simon Lambert, Dec 2013
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