How easy is it to Predict Interest Rates?

When giving advice on mortgages it is important to be able to offer advice about the future direction of interest rates. For example, it makes a big difference as to whether a customer should take a fixed or variable mortgage. The future of interest rates depends upon many factors.

In both the UK and US interest rates are set by the Central Bank. The important factor is that their primary target is the control of inflation. The UK has a specific target of keeping CPI inflation between 1 and 3%. In the US, the Federal Reserve have a similar commitment to keeping inflation low. In recent statements made by….. it is clear the control of inflation remains a high priority.

Therefore, the determination of interest rates depends on forecasts for inflation. If inflationary pressures are forecast to rise then it is likely interest rates will be increased to pre-emptively reduce the inflationary pressures. Inflation is dependent on many factors:

1. Economic Growth and the amount of spare capacity. If the economy is growing above the long run trend rate of growth, the economy will experience supply constraints and therefore inflation. In the US, any growth above 3% is likely to cause inflation.

2. The Housing Market. Interest rates are not set to directly effect the housing market. But a fall in house prices, has a big effect on reducing consumer wealth, confidence and therefore spending. Therefore a fall in house prices is likely to reduce inflation and enable lower interest rates. see: will house prices fall?

3. Supply Side factors. Inflation is not just caused by economic growth and demand side factors. It is also caused by cost push factors. For example, rising energy prices will feed through into domestic inflation  and therefore increased the pressure on interest rates.

Difficulties in predicting Interest Rates.

1. Many factors affect inflation.

For example, a recession in the US housing market doesn’t necessarily mean falling interest rates, why? This is because there are still many other factors affecting inflation. Although there is a record rise in mortgage defaults, it is possible other sectors of the economy are expanding. Also, rising cost push factors can mean interest rates need to remain high, even thought the housing market is in recession.

2. Time lags and difficulty in collecting data

often have difficulty in collecting data about the present situation, let alone forecast future inflation trends.

3. Unexpected events.

There can be both supply and demand side shocks which make inflation prediction wrong. For example, a natural disaster can cause a shortage of oil and energy causing rising cost push inflation. Consumer confidence can also be affected by unexpected shocks such as terrorist action or a bursting of an investment bubble.

Nobody can predict interest rates with certainty. However, in recent years low inflation has meant interest rates have been less volatile than previous decades. However, even if you cannot predict interest rates for your clients it is important to understand the factors that effect interest rates and the housing markets. It is not enough to say what may happen to interest rates, it is important to be able to give a convincing explanation.

• Will Interest Rates rise or fall in 2008?