UK Base Rates

Interest rates have fallen to a a record low because the economy has experienced its deepest recession since the 1930s.

The Bank of England have kept interest rates at 0.5% since March 2009

Factors which will keep interest rates close to Zero in the future.

• Depth of recession and scale of fall in GDP
• Predicted rise in UK unemployment close to 3 million. Labour force survey gives unemployment of 2.5 million, but, this hides some underemployment (e.g. working part time)
• Budget Deficit rising to 12% of GDP means the government is under pressure to improve fiscal position. This will require higher taxes and lower spending. The government’s fiscal stance and promise to cut spending and public sector jobs from 2011 could damage recovery and is deflationary. Therefore as taxes rise and spending falls, it is more likely interest rates will stay low.
• In 2010, there has been temporary rise in inflation due to rising oil prices and tax rises, but, this does not reflect a fundamental increase in inflationary pressures. The underlying state of the economy means there is a lot of spare capacity and little inflationary pressure. This is one of the main factors which will enable interest rates to remain very low.
• UK housing market has shown signs of uncertainty. House prices rose in 2009 and 2010, but in late 2010 and 2011, we could see a further fall or at least stagnation in prices. see: will house prices fall again?
• Given this gloomy outlook for the UK economy, the Bank of England are forecasting low inflation and low interest rates in 2010 and 2011.

Graph showing Interest Rate Predictions

Bank of England Interest Rate Forecasts

Source: Bank of England latest inflation report [link

This suggests many analysts believe official interest rates could stay at 0.5% during 2010.

I believe it is hard to see interest rates rising before end of 2010.

Factors which will push up Interest Rates

• Scale of Quantitative easing (increasing money supply) increases potential for future inflation. As inflation rises, interest rates could rise sharply. However, the impact of quantitative easing has not been fully understood. Broad money growth still shows slow growth. It is likely quantitative easing will be brought to a halt soon.
• As economy recovers, the historic low interest rates could rise to prevent inflation, which has proved more persistent than expected.
• Rates of 0.5% are exceptionally low. At this rate there is a danger of distorting economic activity.

The forecast for interest rates depends on how strong and robust the economy recovery is At the moment, economic conditions are conducive to low rates for several reasons.

• Weak housing market
• ongoing credit crunch and reluctance to lend by banks
• Negative economic growth in 2009, and relatively weak growth or 2010.
• rising unemployment – over 2.5 milliion
• Credit crisis reducing availability of credit

Factors Influencing interest rates in 2010

• Real interest rates are actually negative. Real interest rates are (Nominal interest rates – inflation) = 0.5% – 3% = -2.5%.
• Sub Prime Mortgage Crisis - The effects of the mortgage sub prime crisis are still being felt in the UK, in particular there is a shortage of mortgage credit. The main effect of the sub prime mortgage problems are to make mortgage lenders less willing to give risky loans. It has also affected consumer confidence. The effect of these two factors are to reduce house price growth and consumer spending. This reduces inflationary pressures and makes it easier to enable interest rate cuts.

Fixed Interest Rate Predictions

Despite base rates staying at 0.5%, fixed rate mortgage deals have not reflected the low interest rates. The Bank of England’s figures suggest the average 2 year fixed rate deal climbed to 4.46 per cent during July. Yet, with forecasts for interest rates to remain close to 0%, this suggest the banks are increasing their profit margins. They shouldn’t really rise more, but, weak competition is pushing fixed rate mortgages slowly up.

Predictions for US Interest Rates

As for the US, interest rates have already been cut to 0% – 0.25%, but, this may be insufficient to stave off the problems arising from the US Housing Market. However, with rates at 0.25% there is little more that they can do. Although the economy shows signs of tentative recovery, base rates are likely to remain low for a while.

See also:

• Difficulties with predicting interest rates
• Interest rates explained

Quoted 2 Year Fixed Rate Mortgage Rates

The fall in base interest rates to 0.5% has yet to be reflected in fixed rate mortgages. Despite continued base rates of 0.5%, commercial banks are already  raising their fixed rate mortgages.

Commercial banks have been claiming that the cost of borrowing is going up for them. However, looking at the three month libor (interbank rate) this is not the case. Libor rates have actually come down quite sharply.

3 Month Libor

Note 600 base points is the equivalent to 6.0%. Current Libor rates are just above 1%

Commercial banks may also argue, interest rates are likely to rise in the future. But, as we mentioned in latest interest rate predictions, the Bank of England feels interest rates will stay low for a considerable time.

Why are Fixed Rate Mortgage deals remaining High?

• Less competition in the banking sector following merger between HBOS and Lloyds
• Banks desperate to recoup losses from bad debts and tracker mortgages with 0%
• Stagnant Housing market, making banks less willing to lend mortgages except with good profit margin

Will Fixed Rate Mortgages Become Cheaper?

Probably not. Despite base rates remaining low, the banks show little sign of making fixed rate mortgages cheaper.

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Best fixed rate mortgage deals

Data Source: Bank of England

This graph shows the rapid decline in interest rates and inflation in the past couple of years.

Some now feel the worst of the recession is over, and if the fragile recovery turns into a stronger economic growth, the interest rate cycle could be reversed with rates returning to levels of 5%. This would have a big implication for homeowners who are getting used to base rates of 0.5%.

Given the unprecedented nature of economic crisis, it is more difficult to predict how the economy will recovery. We have witnessed an unprecedented array of economic policies from the largest fiscal deficit since WW2, to Q.E. and zero interest rates. These policies will not continue for ever and the need to quell the rising deficit could hinder future recovery. Also, there are unknown factors such as how the extent of swine flu may impact on economic growth should the pandemic spread.

The most likely scenario is for interest rates to rise gradually during 2010. Despite, quantitative easing, I don’t see a rapid return of inflation. There is too much spare capacity in the economy. Current money supply figures indicate bank lending is far from returning to normal.

Also, next year in 2010 and definitely in 2011, there is a likelyhood the government will have to tighten its fiscal budget. Therefore, with tax cuts expiring and possibly higher tax rates, it will enable the MPC to keep interest rates low to avoid a double dip recession.

Base Rates

With Bank of England Base rates reaching more or less rock bottom (0.5%). The big question is how long will rates stay so low? Interest rates reached 0.5% in March and have kept low through the summer of 2009.

In the experience of Japan, interest rates remained close to zero for over a decade. Basically, Japan got stuck in a deflationary spiral. With asset prices falling for over 12 years the authorities struggled to boost demand, economic growth and any inflationary pressure. If the UK were to get locked in a deflationary spiral, we would see a similar period of zero or very low interest rates.

Interest rates have fallen to 0.5%, but so far there seems no convincing end in sight for the steepest recession since the Great Depression. This suggests conventional Monetary Policy has become ineffective because of the steep asset price falls and stagnation in bank lending.

However, interest rate cuts usually have a time lag (upto 18 months). Combined with expansionary fiscal policy, low value of sterling and new policy of quantitiative easing, there is a good chance of an economic recovery within a year.

The effects of quantitative easing on inflation is hard to quantify. Traditional analysis (in normal times) suggests printing money causes inflation. This link is not as simple though. With falling velocity of circulation, it is possible to increase money supply without inflation. For more details see: effect of printing money on economy

However, when the economy recovers and therefore velocity of circulation increases (number of times money changes hands) we are likely to see an increase in inflationary pressure. The extent of inflation depends on whether the Bank of England can easily reverse the boost in the money supply. This might prove difficult.

When the economy recovers, there is the prospect of inflationary pressure coming back quite quickly. Therefore, we could soon see interest rates increase quickly.

Note: interest rates have fallen so much because rate cuts have become less effective. Therefore, when inflation returns, interest rates may increase to 5% as quickly as they came down.

At the moment, we cannot say with certainty how long interest rates will stay low. The fundamental issue is how long the economy remains in recession. As long as the economy is contracting or we have deflationary pressures, interest rates will stay low. But, as soon as economy recovers and inflation returns, interest rates are liable to rise quite quickly.

However, the size of the budget deficit means the government will have to adopt a more deflationary stance on fiscal policy. Tax cuts will expire and this could harm the economic recovery. If taxes do rise, it means there is more pressure on monetary policy to take up the slack – (keep interest rates low)

So if you can get a good fixed rate deal in the next 12 months, it could prove a very good investment.

What this means is that in 2010 and 2011, the government will bring in tax increases such as (putting VAT back to 17.5% and 50% income tax) Also future public spending will be limited. The combined impact of higher taxes and lower spending will be implemented during a period of weak economic recovery. There is a danger that the policies necessary to reduce the government’s debt burden could push the economy back into recession.

With output and global trade falling so much, tax rises could have an adverse impact on spending and further deflate the economy. Therefore it is more likely that the MPC will be keeping interest rates low for a long time.

I expect the economic recovery to be weak so combined with higher taxes, there will be pressure for monetary policy to remain reflationary.

The prospect for interest rates also depends on the impact quantitative easing has. If quantitative easing causes inflationary pressure to occur sooner than expected, then interest rates will rise. But, if quantitative easing fails to create inflation because of the depth of the recession, we could be seeing a long period of very low interest rates (similar to Japan in the 1990s)

UK interest rates

The Bank of England’s inflation report gives a strong indication that interest rates in the UK could fall to 0 – 0.25%. There is also an increasing likelyhood of quantitative easing – a policy of creating money to avoid the deflationary impact. (B of E report)

The UK is facing its deepest recession since the Second World War (Not for 100 years as a government minister Ed Balls suggested). GDP is forecast to decline by 4% this year, and there is a prospect for further falls if the global economy continues to decline. Combined with falling commodity prices, the high levels of spare capacity is leading to a significant fall in inflation. The Bank forecast inflation of 0.6% this year. If the economy fails to recover in 2010, we could be faced with deflation – something which could be very damaging for the economy.

What is Effect of 0% Interest Rates?

Those with variable mortgages, especially tracker mortgages will be facing very low payments. There is even prospect of some tracker mortgages with 1% off base rate having to pay mortgage holders! (I’m not sure whether banks can get out of that or not, it depends on fine print. Suffice to say when banks offered tracker mortgage deals of 1% of base rate they never anticipated 0% interest rates

Savers will face very limited returns. Savers will struggle to find accounts which offer a decent return. However, many banks are still looking to attract more deposits, so some accounts will offer significantly above the 0% base rate.
The good news for savers is that the fall in inflation will help increase the real interest rate. Currently we have negative interest rates (inflation is above base rates) but the fall in inflation will mean real interest rates will improve. This is good news for savers, though people tend to just concentrate on the nominal interest rate and not real interest rates.

Problems of 0% interest rates

• Banks may struggle to attract deposits. E.g. people keep more cash or buy gold. This could make less deposits available for new mortgages
• Banks may not pass rate cuts onto consumers. Monetary policy becomes ineffective.
• Quantitative easing is unknown territory. It could be inflationary in the long term. Though the threat of deflation could be damaging for UK economy.

Graph of Interest rates since 1985

Base Rates and Commercial Rates

Base Rates and Variable Rates

This graph shows how commercial banks do not necessarily follow the base rate changes. The very low interest rates of 2009, gave many commercial banks an opportunity to increase their profit margins and improve their balance sheets.

Real Interest rates

See: Real interest rate history in UK

Other links for Info on Past interest rate trends

• The Bank of England provide detailed interest rates since 1963 [B of E link]
• e.g. Official interest rates since 1975 at B of E
• Interest rates since 1991 at Guardian

International interest rates

G7 interest rates

US Interest Rates

US interest rates

• Mortgage interest rates explained
• Historical House prices

What Will Happen to Mortgage Rates?

After the Bank of England’s decision to cut interest rates by 1.5%, there was a predictable scrutiny of the high street banks to see whether they would pass the cut on to consumers.

Interestingly, one of the first banks to announce they would pass the cut on was Lloyds TSB and its mortgage subsidiary Cheltenham & Gloucester. The other part nationalised banks, Halifax, (HBOS) and Royal Bank of Scotland have all stated they intend to pass the cuts on. The only two to avoid trimming their rates so far are HSBC and Barclays (both of whom avoided requiring government funds)

However, even if banks do cut their standard variable rate by 1.5% there is no guarantee that all mortgages will be cheaper. In the boom years, anyone with any sense would remortgage to a better mortgage deal. To stay on your mortgage lenders standard variable rate was an expensive mistake to make. What will happen now is that banks will reduce the number of offers and special mortgage deals. The days of tracker mortgages 1% below the base rate are over. It will be harder for people negotiating a new mortgage contract to get a deal which offers any discount on the standard variable rate. For example, the Abbey, Halifax and Nationwide have all been increasing their tracker rates to new customers. The number of tracker mortages on offer has also nearly halved. Therefore, although the banks standard variable rates will be falling, many will not see the equivalent reduction in mortgage payments they might expect.

The Libor Rate

The libor rate is the rate at which banks borrow from each other. This is very important for determining the rate at which commercial banks want to lend. The good news is that this has come down. On Friday the Libor interbank rate fell 1.07% to 4.5% the biggest fall since 1992; suggesting an easing in lending conditions and making it more practical for banks to cut their own rates.

Availability of Lending

As many have pointed out the problem with the credit crunch is that banks don’t want to lend because they are desperately trying to improve their balance sheets. Therefore, although loans may appear cheaper, banks will not be in a rush to lend. With property prices falling, banks will be requiring large deposits to protect themselves against negative equity. Therefore, although mortgages may look cheaper, many first time buyers may still be unable to get a mortgage – even if they would like to get one. – Reducing the cost of borrowing is not really the problem; the problem is a shortage of funds, liquidity and confidence for lending.

The Devil’s in the Detail.

Even people on tracker mortgages may not necessarily find themselves with lower rates. This is because some tracker mortgages have what is known as a collar clause. What this means is that your rate follows the base rate upto a certain point. But, if base rates fall below 3%, the bank does not have to pass the lower rates on. (At the same time, these collar mortgages also often have an upper rate as well.)

Forecast for Interest rates into 2009.

The outlook for medium term interest rates is for them to fall and remain low. Although interest rates have been cut to 3%, many analysts suggest rates could fall to 2% or even 1%. This is because so far, the recession has been much steeper and deeper than expected. Unemployment is rising sharply. Output is falling across different sectors from manufacturing to retail. The housing market continues to drag the economy down.

Inflation is widely forecast to fall sharply from 5% to 2%, some in the MPC now fear that inflation could drop below the government’s target of 1% – raising the ugly prospect of deflation. The bank will certainly be keen to avoid this.

• Investment decisions
• Exchange rates
• Housing market
• Inflation
• and economic growth.

The future direction of interest rates, primarily depends upon forecasts for inflation and economic growth. In the UK, the Monetary Policy Committee have been given an inflation target of 2% +/-1. Thus, if the MPC feel inflation is likely to rise above this target, they will be obliged to increase interest rates in order to moderate demand in the economy. Thus, predictions for interest rates often depend upon predictions for inflation.

At the moment the MPC are verging on the side of caution.

Why Interest Rates will Fall.

• There are various factors to suggest the UK may soon be reaching a peak in the interest rate cycle.
• Many on fixed rate mortgages are soon coming to the end of their introductory period. This means that people who took out a fixed rate mortgage when interest rates were at 4% will soon be facing a significant increase in mortgage costs. For them the impact of the interest rate rises will be delayed and therefore, their spending will be reduced in the future.
• Housing Slump in the US, is spreading to UK.
• Number of mortgage approvals has fallen.
• Global Credit Crunch has led to shortage of credit and difficulty in getting loans.
• Inflation forecast to fall in 2009, due to slowing economy and rising unemployment
  • CPI is forecast to be 4.0% in 2009
  • RPI is also forecast to fall  2009

Why Interest Rates may not Fall in 2008 /09

• They argue that firms have been able to increasingly pass price increases on to consumers.
• The China effect may be slowing down. The China effect states that global inflation has been kept low because of the relentless deflation in the manufacture of goods. However, supply constraints in China may soon lead to inflation and this will be passed onto importers like the UK.
• MPC worried about inflation from rising oil and energy prices.

The economy is slowed down much more than the MPC expected, therefore, the chance of substantial interest rate cuts has increased. The slowing economy will help reduce inflation, giving the MPC the ability to cut rates and try and prevent a severe recession.

The government will also be hoping that interest rate cuts may help the beleagured banking sector and avoid more bailouts such as Northern Rock, Bradford & Bingley and HBOS. The government has already taken on mortgage securities of £150bn it will want to avoid future bailouts if at all possible.

Does the Strong Exchange Rate influence interest Rates?

No, at least, not directly. The MPC is concerned only with an inflation target; it does not have an exchange rate target. Therefore, it will not cut interest rates to reduce the value of sterling.
Also, the £ is primarily strong against the dollar, due to the weaknesses of the dollar.

Related Posts

• Higher interest rates for Record Debt Levels
  
• How do Interest Rates effect Housing Market
• What determines interest rates in the UK?

[1] Forecast for UK economy 2007 PDF document

Yesterday, the nine members of the MPC voted to keep base interest rates unchanged at 5%. What explains their decisions to change rates?
The MPC have an inflation target of CPI 2% +/- 1 set by the Government. Therefore, predictions of future inflation are the most important factor in determining interest rates.

To predict inflation trends they can look at several things.

1. Economic growth compared to the long run trend rate of growth. If growth is above long run trend rate, then Aggregate Demand will be increasing faster than Aggregate Supply and this causes demand pull inflation. If growth is forecast to rise above a ‘sustainable rate’ the MPC are likely to increase interest rates. At the moment, growth is slowing down, demand pull inflation is relatively subdued
2. Cost push inflation. Rising oil prices and food prices cause cost push inflation. This is the real problem at the moment. Rising oil prices are causing rising transport prices, rising energy prices and increasing food prices. In fact, it is argue that CPI underestimates the real inflation because CPI exclude some of these factors. Cost push inflation is more problematic because cost push factors will be causing slower growth. To reduce inflation the MPC needs to cut interest rates. But, this will make the slowing economy even worse. Therefore, there is a trade off, the MPC can reduce cost push inflation but, it will be at the cost of rising unemployment and slower growth.
3. Wage inflation. Rising wages can cause both demand pull inflation, and higher cost inflation. At the moment, wage inflation is relatively subdued.
4. Exchange Rate. A depreciating exchange rate might cause inflation (rising demand for exports and increasing price of imports) therefore, the MPC might be inclined to increase interest rates. Furthermore, the higher interest rates may help to boost the currency.
5. Consumer confidence
6. House prices – falling prices reduce consumer spending
7. Unemployment. rising unemployment should reduce inflationary pressure
8. Manufacturing output
9. Levels of investment and levels of spare capacity

At the moment, the MPC is being pulled in two ways. Inflation is increasing because of rising oil prices. But, the economy is slowing down because of the credit crunch and falling prices. They have weighed the two up and decided to just leave things as they are. They probably hope that the slowing economy will reduce inflation in the future and therefore they may be able to cut rates later in the year.

However, it is interesting that the MPC have a target only for inflation. The Fed reserve have a target for both low inflation and higher growth. Some argue the MPC focus too much on inflation and actually should be cutting rates to avoid the real prospect of recession.

See also: Interest rates explained

• Predictions of interest rates