Interest rates have remained at record low of 0.5% since March 2009. Interest rates are likely to remain at 0.5% for the next several months because the economy is still struggling to recover from one of the longest recessions on record. In fact economists are now predicting that the current climate of ultra low interest rates may last into 2016.
With inflation still above the governments target of 2%, the Bank of England have faced some pressure to raise interest rates. The Bank of England face a dilemma. On the one hand the economic recovery has been sluggish and slow. Unemployment is still high and the governments austerity measures – spending cuts and tax rises are likely to keep spare capacity in the economy. However, 2012 has seen a fall in the inflation rate (which was predicted by the Central Bank. The latest inflation figures show inflation falling to 2.5% (Sept 2012). This increases the likelihood interest rates will remain at zero throughout 2012 and into 2013. Though some commentators feel the fact inflation is staying above the target suggests, interest rates should be increased.
Headline inflation CPI has been above the government’s target of 2%. But, these inflationary pressures are mainly 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 the scale of the economic downturn, this is not materialising. Also, these cost push factors are slipping away (though there are fears of rising food prices in 2013)
(note: CPI-CT excludes impact of taxes.)
Why Inflation is still above 2% in 2012
- rising taxes
- Impact of devaluation (though with appreciation in Pound) this is evaporating.
- effect of rising commodity prices
This dilemma has caused a divergence of opinions 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 partly vindicated that the spike in inflation in 2011 was actually due to temporary factors. Though it hasn’t fallen as much as they predicted yet.
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:
Deeper recession than the great depression.
- 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 2012, inflation has remained high 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 has stagnated, we could see a further fall or at least stagnation in prices in 2012. 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 3%, 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 once called for interest rates in the UK to rise to 2.25% by the end of 2012. But, this looks increasingly unlikely given sluggish growth.
- 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 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% – 35.5% = -3.0%.
- 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.