Could Interest Rates Stay Low For Years?

21.07.10

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Following the UK?s emergency Budget in June many of the headlines focused on the spending cuts and tax hikes, with much debate on how they would affect economic growth. Another issue ? one which

Following the UK?s emergency Budget in June many of the headlines focused on the spending cuts and tax hikes, with much debate on how they would affect economic growth. Another issue ? one which affects many expatriates who keep savings in Sterling – is the impact the Budget measures will have on UK interest rates, with most economists agreeing that the Bank of England base rate will now not rise for months and possibly even years.

When more savings cuts were announced than expected, many economists pushed back their estimate of when the first interest rate rise will come. At the beginning of May, 55% of economists polled by Reuters expected an increase by the end of this year. The number dropped to 30% in June and to 28% on 1st July.

Median forecasts have now moved from the first quarter of next year to the second quarter. These forecasts expect two hikes between March and June 2011, taking the rate to 1%, and for the bank rate to end 2011 at 2%.

Some economists expect it to take longer for rates to rise. Douglas McWilliams, chief executive at the Centre for Economics and Business Research, said ?we now think that base rates will be stable at 0.5% until the end of 2012? and Roger Bootle of Capital Economics commented that he is ?extremely comfortable with my forecast that the Bank Rate will be at 1% or below for five years?.

While savers would disagree, Ed Stansfield of Capital Economics described the fact that interest rates are likely to stay low as ?one positive to emerge from the emergency budget?.

Business lobby groups have warned that a rate rise would halt recovery as companies would struggle to meet higher costs and banks would be concerned that more borrowers would struggle to meet their repayments. Lower rates also suit equity investors as more people will invest to avoid losing money in real terms by leaving savings in the bank while prices are rising.

If the government?s projected growth figures for the next five years are to add up, interest rates will need to be kept low over the period. The Bank of England appears to be supportive of Chancellor George Osborne?s plans to speed up deficit reduction measures and is expected to co-operate with a low bank rate even if inflation is a little above target.

In a speech at Mansion House a few days before the Budget, BoE governor Mervyn King said that ?monetary policy must be set in the light of the fiscal tightening over the coming years?.

While he has also said that the Monetary Policy Committee (MPC) would not hesitate to raise rates ?when it becomes necessary?, if it continues to believe (as set out in its May inflation report) that inflation will be below the 2% target in two years time, in theory there is no need for a rise in the near term.

The fact that the Osborne delayed the VAT rise to 20% until next year is a sign that he does not want interest rates to increase. One reason he was critical of the previous government?s plans to tackle debt was because they would have led to higher interest rates.

Higher VAT will increase the cost of living and would have put pressure on the BoE to raise interest rates if implemented this year since inflation is already running above target. However if the BoE predictions are correct this will be less of an issue next year.

In June one MPC member, Andrew Sentance, did vote to increase interest rates – the first to do so since August 2008 ? and he did so again in July. He favours a gradual rise in the bank rate to avoid destabilising confidence through a ?sudden lurch in policy?, and has said that the current ?extreme? monetary policy is no longer warranted.

However he is just one of eight members and the others voted against him, with some even believing that the case for a rise has weakened over recent months.

Prior to the July MPC meeting, comments by other members dampened any hopes of a rise. Paul Fisher warned that tightening monetary policy too early would stifle the nascent recovery and result in more company failures and higher unemployment. He said that the risk of deflation has not completely gone away and that the MPC has tools in its armoury to manage inflation if necessary.

David Kauders, a gilt specialist, has described the high interest rates over the last 30-40 years as an ?aberration? since previously rates were around 2% for centuries. He believes that it would be counterproductive for the government to continue to use rates to manage the economy. He has warned that if rates do go up this will result in too many repossessions and the Bank would soon cut the rate again. He was quoted in The Telegraph as forecasting that ?interest rates are likely to stay around 0.5%, give or take a quarter or half a point, for 10 to 20 years?.

Savers will hope that this prediction does not come to pass and will take heart that other economists are calling for a rise sooner rather than later. Henderson chief economist Simon Ward has argued that an early rise is warranted to boost demand for money to eliminate surplus liquidity and to increase the UK?s attractiveness to foreign investors.

There are also still fears that the amount of money the BoE has pumped into the economy will inevitably lead to very high inflation over the coming years and therefore rates should be increased soon to prevent this.

On the other hands the fear of deflation has not gone away. The government does not have many tools left to tackle falling prices and since deflation is difficult to turn around many people prefer the risk of inflation over that of deflation.

If you require your savings to generate an income you could consider investments such as bond funds, real estate investment trusts or high dividend equity funds, which pay out regular income. This allows you to receive income without the risk of having to withdraw capital.

A wealth management firm such as Blevins Franks will advise you on what opportunities and strategies would be appropriate for your objectives, circumstances and tolerance to risk.

By Bill Blevins, Managing Director, Blevins Franks

21st July 2010

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.

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