Prospects for Interest Rates

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