Interest rates have become the main tool for influencing the Economy in both the UK and US. Interest rates have a significant impact on all aspects of the economy including:
- 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
when will the base rate of intrest rise again to around 4%