Interest Rates in the UK

Interest rates are a tool that central banks use to implement monetary policy. They represent the percentage rate at which interest is paid by a borrower for the privilege of using money that has been lent to them and the interest can be paid at various time intervals. Higher interest rates will have an impact upon inflation and employment and could lead to a reduction in consumer spending and investment. The Bank of England meets every month to set the UK bank rate. There are nine members of the Committee and they are appraised of all the latest data on the economy and business conditions. Their task is to keep inflation below 2% but above 1% in the following 2 years.

In the UK the current rate of interest, also known as the base rate, as set by the Bank of England, is 0.5%. This is an historically low level which has been in place for the past 5 years in order to aid the country's recovery from the recession brought about by the financial crisis. It is anticipated that interest rates will have to rise sooner rather than later, although there is much speculation about the date of the first rate rise which is anticipated to be in the first half of next year. The new normal level for rates is expected to be 2 to 3%, well below the 5% from the late 1990s to the financial crisis. In 1976 interest rates hit 15% and double digit interest rates were not uncommon between 1975 and 1991.

Mark Carney, the governor of the Bank of England, and Charlie Bean, the outgoing Deputy, have both indicated that rates will peak at around 3% in 3 to 5 years time, below the pre-crisis average of 5%. There have been indications that rates may start to rise in the next 12 months and in the latest minutes of the Bank of England's meeting it seemed that a decision was now more finely balanced than in recent years. It is essential that the Bank of England raises rates slowly so that it does not choke off the recovery that is beginning to come through. Britain's economy is growing faster than any of the other Group of Seven countries at an annual rate of 3% and it is not clear what impact an interest rate rise would have on the economy after the long recession.

Charlie Bean has suggested that any rises are in "baby steps" in order to avoid making mistakes. In other words he thinks the Bank should be cautious - this could entail raising rates soon - but at a smaller rate than has been implemented in the past, for instance at a rate of increase of 0.1% instead of the previous normal rate of 0.25%.

It is generally accepted that low interest rates are inflationary and the Bank will be watching for early signs that this is happening and try to move interest rates up early to forestall it. Generally they would raise interest rates if they were concerned that inflation was on the increase in order to reduce demand and slow the rate of economic growth. At the present time there are no signs that inflation is picking up with the latest CPI figure coming in at 1.8% which may be attributable to the output gap.

Interest rate movements have the largest impact for individuals on savings, mortgages and annuities, whilst for businesses it impacts the level of demand, interest on loans and the present value of assets and liabilities.

Over the last 5 years savers have been badly hit by the low level of interest rates. This has been particularly hard for pensioners with savings. Higher interest rates would make it more attractive to save cash in deposit accounts as the level of interest received would be higher than at present, thus reducing the need to take on extra risk to earn a decent reward.

At the same time interest payments on credit cards and loans would increase making them more expensive to use and would act as a disincentive. Those who have existing loans may find them harder to finance due to higher interest payments and this could reduce their spending in other areas.

In Britain there have been concerns about the housing market recovery and the possibility of a bubble forming, particularly in London. The Bank of England will be more concerned about the risks of a large increase in debt than about price growth due to a lack of supply. If interest rates rise mortgage payments linked to the variable rate will also rise and new mortgages will also be issued at a higher rate. This would also have the impact of a brake on spending as disposable income would be reduced. For instance a 0.5% rise in interest rates would increase the payments on a £100,000 mortgage by £60 a month.

Annuity rates have been very low during the financial crisis as they are linked to interest rates via the 15 year gilt or government bond yield. When interest rates rise annuity rates should also improve. Those retiring in the coming years should be able to secure a higher income. A half a percentage rise in interest rates could see yields on the 15 year gilts rise by 50 basis points which could result in a 5% rise in annuity rates whilst if interest rates reach 1.75% annuity rates could be 12.5% higher.

The value of sterling would increase if interest rates rose. International investors would be more likely to use British banks for their savings if the interest rates in the UK are higher than in other countries.

A strong pound also makes British exports less competitive which could have the effect of reducing exports and increasing imports thus reducing the overall demand in the economy.

Interest rate rises also have the general effect of reducing confidence both for the consumer and business which has the effect of discouraging risk taking and investment.

Predicting when rates are likely to increase is difficult. One indicator that may help to predict when interest rates are likely to rise are the overnight swap rates which often influence the market rates of fixed mortgages and fixed rate savings bonds.

Darren Winters