The Base rate is the rate set by the Central Bank. It is the most important interest rate in the economy because it influences all the other interest rates. If the Central Bank cuts its base rate, it means it is cheaper for commercial banks to borrow from the Central Bank, this usually encourages them to cut interest rates.

Base interest Rates since 1800

In the nineteenth Century, interest rates were less volatile. During the Great Depression, interest rates were cut to 2% (despite strong deflation during this time). In the 1970s, interest rates rose into double figures because of the high inflation caused by the oil price shock and rising wages. The current interest rates of 0.5% (since March 2009) are unprecedented – especially in the context of the post-war period.

Base Interest Rates since 1900

Base Interest Rates since 1945

Interest rates – Inflation = Real Interest Rates

The real interest rates is very important for determining whether savers are gaining or losing. If inflation is higher than interest rates, it means the value of money is declining more than the return from savings. A negative real interest rate leaves savers worse off.

In the First and Second World War, savers lost out considerably because inflation was substantially higher than interest rates.

• In the early 1970s, savers also experienced negative real interest rates.
• 2009-2011 has seen a return of negative real interest rates due to cost push inflation and record low interest rates.

Inflation and Interest Rates since 1945

Inflation and Interest Rates since 1979

interest rates (blue) have primarily been above interest rates, until 2009.

Mortgage SVR Rates
Usually commercial banks follow the lead of the Bank of England. If base rates fall, commercial banks cut their Standard Variable Rates (SVR). However, in the credit crunch since 2009, banks didn’t cut rates by as much as the bank of England leaving a big gap between commercial bank rates and Base rates. This was because the commercial banks were short of funds so trying to encourage deposits rather than more lending.

Government Long Term Bond Yields
This is the interest rate on long term government bonds.

Related

• Predictions for interest rates
• Historical interest rates
• Bank of England Statistics
• Interest rates and housing market

Headline inflation CPI has been above the government’s target of 2%. But, these inflationary pressures are caused by cost push factors such as rising oil prices, rising commodity prices. There have been concerns that these cost push factors could cause underlying inflationary pressures to rise. But, given scale of economic downturn, this is not materialising.

(note: CPIY excludes impact of taxes.)

Why Inflation was high in 2011

• rising taxes
• Impact of devaluation
• effect of rising commodity prices
• Therefore in 2012, they expect inflation to come down sharply.

This dilemma led to a split in the Bank of England. However, with worries over a double dip recession, and a fall in inflation, interest rates are now unlikely to rise before the end of 2012. In fact the Bank ordered another round of quantitative easing towards the end of 2011. The Bank also feels vindicated that the spike in inflation in 2011 was actually due to temporary factors.

Latest Inflation and Wage Growth

Very low wage growth means underlying inflation is low, and therefore the Bank of England will be keeping interest rates low.

Inflation Forecast 2012

After peaking in 2011, the Bank of England expect inflation to fall below the government’s target of CPI 2%, by the end of 2012. They expect lower inflation because:

• Ending of commodity price rises
• Tax rises no longer affecting CPI
• Very weak demand due to ongoing recession, spending cuts and squeeze in real wages.

Factors That have kept interest rates low for considerable time:

• Depth of recession and scale of fall in GDP. UK GDP still below 2008 peak. Recovery has been very weak. 2012, is likely to see a mild recession
• 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 11-12% of GDP means the government has taken steps to improve its fiscal position. The combination of higher VAT rates and lower spending has reduced confidence and consumer spending. This fiscal drag is likely to lead to economic growth below the long run trend rate. Therefore, in theory it is still hard to see inflation caused by demand pull factors.  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.
• The squeeze on consumer spending is set to continue with higher tax, spending cuts and job losses.
• In 2011, 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. Wage growth is still low. (see: Real wages UK)
• 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?

Factors which will push up Interest Rates in the future

• Inflation has been stubbornly above target. Despite lack of economic recovery, inflation has been persistently above target. This has not led to wage inflation, but it has changed inflation expectations. With inflation running above 4%, there is still some pressure to increase nominal interest rates. However, this is likely to evaporate as headline inflation falls.
• 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 and are leading to a negative real interest rates.
• Also at this rate there is a danger of distorting economic activity, e.g. encouraging speculation.
• The OECD have called for interest rates in the UK to rise to 2.25% by the end of 2012. But, this looks increasingly optimistic.
• Andrew Sentance of the Bank of England has warned the Bank risks losing its credibility if they don’t push up interest rates to keep inflation low.

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
• Weak economic growth in 2011 and 2012
• Rising unemployment – over 2.6 million
• Credit crisis reducing availability of credit

However, the persistence of inflation, raises scope for increasing rates.

Factors Influencing interest rates in 2012

• Real interest rates are actually negative. Real interest rates are (Nominal interest rates – inflation) = 0.5% – 4.2% = -3.7%.
• How much of current inflation will prove temporary?
• How will volatility in the Eurozone affect the UK economy and its chances of recovery?
• Will bank lending get back to normal?
• 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.

UK Economic Forecast

Economic growth forecasts for 2012 are split. The OBR and Bank of England are more optimistic that the UK will avoid a technical recession; they forecast positive growth of around 0.7%. However, other private forecasters anticipate a fall in GDP. Standards & Charter expect the economy to contract by 0.6% in 2012.

• see: UK economic forecast at economicshelp.org

Fixed Interest Rate Predictions

Despite base rates staying at 0.5%, fixed rate mortgage deals have not reflected the low interest rates. This suggests the market expects interest rates to rise. But, also banks are trying to improve their profit margin and increase their reserve ratios.

Mortgage Rate Predictions

Another issue for home-owners is that mortgage interest rates have lagged behind the Bank of England Base rate. When the Bank of England cut base rates from 5% to 0.5%, most banks did not pass this cut onto consumers, meaning the average Bank Standard Variable Rate remained at 4%. Despite three years of zero interest rates, bank SVR rate’s have slowly crept up.

Banks are unlikely to cut SVR rates whilst they remain short of cash and nervous over bank lending.

However, the good news for mortgage holders is that when the Bank of England increase base rates, there will be a much smaller increase in standard variable rate.

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
• See our predictions on house prices and mortgage interest rates for 2012.
• Interest rate graphs

Graph of Interest rates since 1979 – 2011

UK Base Rates

Base Rates and Commercial Rates

Bank of England Base Rates and Standard 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. In reality, the banks were short of cash and so kept their standard variable rates higher than the Bank of England base rate.

Real Interest rates

• Real Interest rates take into account inflation.
• Real interest rate = nominal interest rate – inflation.

In the period of economic expansion from 1997 – 2007, base rates were significantly higher than CPI inflation. This is good news for savers because it means that the rate of return from saving in a bank is greater than the amount money reduces in value due to inflation.

After the credit crunch, there was the unusual situation of base rates being lower than inflation, leading to a negative real interest rate.

Base rates were cut to 0.5% in March 2007, this remains a record low for UK base rates.

Economic Impact of Interest Rates

The Bank of England set interest rates to try and meet the government’s inflation target of CPI = 2% +/-1. If inflation is above target, the Bank are likely to increase interest rates to reduce the growth of demand and therefore reduce demand-pull inflation.

However, as well as targeting low inflation, the Bank of England is also concerned about economic growth and unemployment. If the Bank of England fear the economy will contract and enter into a recession, they will want to keep interest rates low to boost spending and economic growth.

See also: The Economic effect of interest rates at economicshelp.org

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

• Mortgage interest rates explained
• Historical House prices

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.

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.

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[1] Forecast for UK economy 2007 PDF document