The effects of Rising interest rates on UK economy

November 13th 2006

Summary: The effect of Rising interest rates on housing market and UK economy

The Bank of England recently announced a rise in interest rates of just 0.25% but hinted that interest rates may rise as high as 6%. These rates are low compared with the early 1990s when within the ERM interest rates reached a peak of 15%. However despite the relatively low levels of interest rates. There are important factors to consider. Firstly the real interest rate is very high. The real interest rate is the actual interest rate – inflation. With core inflation remaining low around 2% the real interest rate is becoming quite high. This is good news for savers but bad news for the UK borrowers. Secondly the UK is experiencing record levels of debt, especially amongst consumers. This is partly because of increasing willingness to borrow but also because of rising house prices. This means to get on the property ladder consumers are increasingly having to get increasingly large mortgages.

Many home owners are borrowing much more than the historical levels. The old formula of a mortgage 3 times your salary is being replaced by mortgage deals that can be 5 or 6 times your salary. The effect of this is that consumers are increasingly indebted and mortgage payments take a higher % of people’s income. Therefore this means that consumers will be increasingly effected by rising interest rates.

The first and most obvious impact of rising interest rates is that it will reduce consumers willing to borrow and spend. Interest payments are more expensive, and increased mortgage payments reduce disposable income. Also saving money becomes more attractive. However the impact of rising interest rates on consumer spending is always uncertain. There are often time lags in reducing spending patterns. A lot depends on how consumer confidence is effected. If consumers start to feel interest rates will continue to rise and the economic cycle may start to swing into a downturn their spending could fall significantly. This will lead to a fall in spending, or at least a fall in the growth of spending and could lead to a downturn.

It is also worth considering the effects of rising interest rates on the manufacturing sector. Rising interest rates are likely to further increase the value of the £ which according to many commentators is already overvalued by historical standards. Therefore with a stronger £ exporters are likely to face decreased profit margins and this could lead to a fall in exports. With a decreased manufacturing sector, rising value of the £ has less effects than it perhaps did previously. Nevertheless rising interest rates will do nothing to lift the long standing gloom over the manufacturing sector.

However on the other hand economists point to the need for rising interest rates. The economy remains relatively buoyant and a small rise in interest rates now will help to bring borrowing under control. If borrowing is allowed to increase now. Their may be a more painful readjustment in the future.

The one group of society who are the real gainers from this current situation is savers. They are enjoying one of the highest real rates of interest for a long time. And judging by the sentiments of the MPC at the last monthly meeting their profitable saving return may continue for a while.