Prospects for Interest Rates in the UK May 2007

Today, Thursday 10th May, the Bank of England increased interest rates to 5.5%. This is the highest rate since October 2001. Interest rates have increased by 2% since a low of 3.5% in 2003.

The main reason for the increase in interest rates were:

  1. CPI Inflation increasing to 3.1%. This is just above the government’s target, last month the governor of the Bank of England had to write a letter of explanation to the Chancellor.
  2. House Price inflation increasing to 10%. Despite recent rises in interest rates, it doesn’t appear to have stopped the buoyant housing market. However, much of this increase in prices stems from a shortage in supply.
  3. The old RPI measure of inflation is even higher at over 4%

Why Interest rates in UK may have now Peaked.

  • Inflation is forecast to fall.
    Recent rises in inflation were due to cost push factors such as rising energy prices. With gas prices now falling from a temporary peak, this is likely to push inflation back within target.
  • The economy is not in a boom and bust situation.

With economic growth of around 2.6% it is very close to the long run trend rate. This means there is little scope for inflationary pressure from growth constraints.

  • The exchange rate has been very strong.

Against the dollar it has reached $2 to £1. The strong exchange rate helps to reduce inflationary pressures. If interest rates continue to rise, it will cause further problems for hard pressed exporters.

  • High levels of debt in the UK:

This mean that small increases in interest rates will have a big effect. Even a quarter % rise in interest rates adds £14 onto a £100,000 mortgage. With mortgage interest payments accounting for a record % of disposable income, interest rates will start to have the desired effect soon.

  • Time Lag of interest rate rises.

Interest rates have been increased 4 times since last summer, it seems they have had little impact on reducing inflationary pressures. But, it is estimated that interest rate increases take 18 months to have a full effect, therefore, in the coming months previous interest rate rises will start to have an effect.

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