Finally, An Interest Rate Rise!

14.04.11

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On 7th April the European Central Bank became the first major western economy to increase interest rates since July 2008. It is too early to call it the end of the era of low interest rates but t

On 7th April the European Central Bank became the first major western economy to increase interest rates since July 2008. It is too early to call it the end of the era of low interest rates but the move is certainly a step in the right direction for savers who have been earning negative real rates of return for too long. The question now is when the next increase will come and will it be another Euro hike or will Sterling interest rates finally lift off 0.5%?

The European Central Bank (ECB) base rate was increased from 1% to 1.25%. The announcement came less than 24 hours after Portugal sought financial assistance from the European Union, so the timing would have been surprising if the Bank had not been warning that it was likely to make the move. It is a signal that it believes ?emergency? rates are no longer required, but the primary reason for the move was as an attempt to combat inflationary pressures.

ECB members had been calling for the ?normalisation? of Eurozone interest rates and were particularly concerned that the increase in the cost of living caused by oil and global commodity prices would lead to wage inflation. The Bank?s inflation target for the Eurozone is 2% but it hit 2.6% in March.

This actually seems tame compared to the UK?s which was 4.4% at the time, so considering lower rates would be more beneficial for the weaker Eurozone economies one may have expected the ECB to hold off for a while longer.

However ECB president Jean-Claude Trichet does not want inflation expectations to start rising. On announcing the rate rise, he said that it was ?essential that recent price developments do not give rise to broad-based inflationary pressures over the medium term?.

He went on to add, however, that the Bank ?did not decide today that it was the first in a series of interest rate increases?. This is disappointing to savers who were hoping the ECB would indicate that it was launching a series of rate increases. They may now have to wait some months for another rise.

Some commentators criticised the move for favouring the larger Eurozone economies of Germany and France, but Trichet said that acting against inflation was ?in the interest of all the members and partners of the single market and single currency? and would help boost economic confidence.

Bank of England

On the same day the Bank of England (BoE) voted to keep its base rate at 0.5%, where is has been stuck since 5th March 2009. This was despite high inflation of 4.4% at the time – more than double the target.

Some Monetary Policy Committee (MPC) members have been voting for a rise to prevent inflation expectations escalating, but the majority believe rates should be left unchanged as household incomes are already squeezed enough and austerity measures could hamper growth.

Inflation has been stoked by the high global food, oil and commodity prices but at the same time the UK?s economic recovery remains fragile. The Bank has been facing the dilemma of whether to fight inflation or aid growth for some time, but high inflation does not necessarily make the decision easier.

Business leaders and economists warned about the dangers of a premature rise, with the British Chamber of Commerce appealing to the MPC to postpone interest rate increases ?until the recovery is more secure?. Business groups welcomed the decision to hold rates on 7th April. The Institute of Directors said that maintaining economic growth is more important than keeping inflation in check:

?Right now is not the time to be throttling off the growth we have started to see. Inflation is an issue but wages remain pretty low and the Bank doesn?t have that much control over commodity prices.?

Many MPC members will want to see evidence that the economy is strong enough to handle higher interest rates before making a move. Since they believe the current high inflation is the result of temporary price shocks which will ease, there is perhaps no need to risk raising rates yet.

Savers continue to be unfairly penalised by low interest rates ? the difference between the base rate of 0.5% and the Consumer Price Index of 4.4% was quite staggering.

They may be cautiously encouraged by the European interest rate rise as it will put more pressure on the BoE to follow suit, but the surprise fall in inflation for March (to 4%, down from 4.4%) announced on 12th April supports the case for the Bank to postpone interest rate increases until the economy is stronger. While just a week previously traders had factored in a 50% change of rate increase in May, after the inflation announcement this reduced to just 20%. Many traders and commentators now expect the first rise to be in August or the autumn.

Even when rates do start to improve, if you are saving for the longer-term, for example to help fund your retirement years, leaving most of your savings in cash can be a risky strategy because of the low likelihood that they will keep pace with inflation. For a review of your financial planning and recommendations for your personal situation speak to a wealth management advisory firm such as Blevins Franks.

By Bill Blevins, Managing Director, Blevins Franks

13th April 2011

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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