At some point rates will no doubt rise, but the consensus forecast is that this many not happen until 2015 at the earliest.
Hitting target not necessarily a good thing
The news this week that inflation fell to its target level of 2% further reduces the pressure on the Bank of England to increase interest rates any time soon.
However, this low growth/low interest rate environment in which we find ourselves is perhaps not a bad place to be. There are plenty of opportunities for stock-picking fund managers, and no shortage of investors looking at risk assets such as equities to generate both capital growth and income.
The implications of a significant rate increase could actually be catastrophic for both the economy and investors. As recently as 1989, the UK interest rate peaked at just below 15%, hitting 14.875% in October that year. Mortgages have never been cheaper than they are right now, but imagine how much the average mortgage would increase by if interest rates reached anywhere near that level. I dread to think how much my mortgage bill would be each month. We would see high rates of mortgage defaults and the consumer would take a big hit.
The knock-on effect of that would be a slump in certain areas of the economy, not least the retail sector, as the proportion of people’s earnings required to service their mortgage would increase dramatically. That would discourage fund managers from investing in retailers, as well as any other parts of the market sensitive to the interest rate cycle. On the flip side, there would be a significant rise in rates paid on savings, but as a nation who in general do not save enough, that would be unlikely to make a material difference for most.
Cash in the bank
Overall, businesses invest less when interest rates increase, largely because the cost of borrowing money increases. A significant increase in interest rates would mean companies would need to devote more resources to paying interest on their existing debts, which would reduce the amount available for investment. Stock markets often decline on news of rate rises for these very reasons.
Of course this is something of a doomsday scenario. What is far more likely is that as and when interest rates do rise, it will happen in a gentle and controlled fashion, and the Bank of England will do everything in its power to keep the rate under control. This, done in the right way, should provide the necessary stimulus for the UK economy and for investors in it.
Anthony Doyle, investment director and fixed income specialist at M&G, believes there a number of reasons why the BoE should hike interest rates sooner rather than later. He notes that asset price bubbles are forming, unemployment is falling towards 7%, and the Taylor rule suggests interest rates are way below neutral. The Taylor rule provides a rough benchmark of the normal reaction to economic conditions as it relates interest rates to deviations of inflation from target and the output gap.
Mind the gap
According to the Taylor rule for the UK, a base rate of 0.5% is around 2% below where it should be given current rates of growth and inflation.
“The BoE must walk the tightrope between raising rates slightly now to avoid higher inflation and financial instability or risk having to do a lot more monetary policy ‘heavy-lifting’ down the line,” says Doyle. “A base rate at 0.5% is way below a neutral level and the BoE has a long way to go before getting anywhere near this level. It could act this year and gradually start raising interest rates to lessen the continued build-up of financial imbalances. The difficult action in the short run to raise the base rate will help to support ‘healthy’ economic growth in the long run.”
