The Bank Of England Inflation Report And Interest Rates

24.05.11

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While the Bank of England interest rate has remained stubbornly unchanged since March 2009, the same cannot be said for interest rate forecasts which have been changing from one month to the next,

While the Bank of England interest rate has remained stubbornly unchanged since March 2009, the same cannot be said for interest rate forecasts which have been changing from one month to the next, sometimes from one week to the next. The lesson to be learned here is that we cannot rely on such forecasts and if you need your savings to generate more income for you, you should discuss your options with a wealth manager rather than just hoping for rates to improve. Even when they do, if you need to protect the value of your capital from inflation over the longer-term you probably should not leave all your savings in cash anyway.

Having said this, we did finally get a slight hint from the Bank of England (BoE) that it may raise the base rate later this year, and the Eurozone has already seen a small improvement in its base rate.

At the beginning of May market expectations were that we would have to wait until next year for the Sterling interest rate to improve.

Roger Bootle of Capital Economics went further by saying that he thought rates ?should stay low for a long time? and that the BoE was unlikely to raise rates till 2013. ?The economic recovery does not yet look strong enough to justify tighter monetary policy. We think that the markets are premature in expecting rates to rise next year.?

On 2nd May the BoE governor, Mervyn King, told the European parliament that ?the economic consequences of high-level indebtedness now would be more severe if rates were to rise?.

None of this is what savers want to hear. However, on 11th May the BoE released its quarterly Inflation Report and, in presenting it, King appeared to pave the way for a rate rise.

The report is not really encouraging reading, with warnings of downward pressures on economic growth combined with continuing upward pressure on inflation – a combination which makes interest rate decisions rather difficult for the Monetary Policy Committee (MPC).

King acknowledged that the recovery will be weaker than previously expected and that Britain faces ?a difficult time ahead with a slow adjustment to the financial crisis?.

However, he said that after the ?soft patch? at the end of 2010 and early 2011, Britain is now seeing a genuine recovery.

According to King?s inflation forecasts, it will remain ?uncomfortably high? and is on track to hit 5% this year and be higher than the Bank?s 2% target next year as well.

This reflects the VAT increase and higher energy and import prices. The Bank forecasts a 15% rise in domestic gas bills and a 10% hike in electricity in the second half of this year. Its previous report only expected a 5% rise in gas prices – the difference triggered by unrest in the Middle East and North Africa.

At the same time the BoE downgraded its growth forecast for 2011 yet again, and this time also downgraded its 2012 forecast.

The UK continues to import more than it exports, though King still believes exports will lead the way to Britain?s recovery ? a factor that would ideally require Sterling to remain weak. The rebalancing of the economy from consumer and public spending to exports will however take several years.

Even with the weak outlook, King signalled the possibility of a rate rise this year, saying that the Inflation Report ?does suggest that the Bank rate cannot stay at this level indefinitely?.

However he also said that ?I don?t think it tells you which month it will rise? and advised that we should not read too much into rate projections.

While some commentators reacted to the report by saying the BoE could raise the base rate as soon as August, others say it will probably be at the end of the year and only a small 0.25% increase. We should not expect steep increases – King said commercial lenders still found it very expensive to raise money and that this was an argument for low official rates.

At the beginning of May the British Chamber of Commerce and Institute of Directors had urged the MPC to keep rates at 0.5%, saying that any rise would damage the economy, and they are unlikely to change their mind in the short term. Graeme Leach, chief economist at the IoD, said:

?A rate rise would do more harm than good. The source of inflationary pressure in the UK is either fiscal (VAT) or global (commodity and oil prices), and so a rate rise would do little to alleviate these pressures.?

If the economy is the more dominant concern a rate rise in the near term is less likely and the Bank may prefer to wait until there is reliable evidence that the corporate recovery is fully under way before making a move.

The situation is a little different in the Eurozone, with the European Central Bank increasing its base rate in April. On 5th May President Jean-Claude Trichet however signalled that the pace of increases would not be as rapid as some analysts expected and the Bank ruled out another increase in June.

Money left in the bank is almost guaranteed to be eroded by inflation when low interest rates and tax are taken into account. As reported in the Financial Times, savers are becoming tired of waiting for interest rates to improve and are moving money into other assets such as corporate bonds. As more money is moving across, prices are rising.

Also positive for high yield corporate bonds is the increased confidence in financial markets which translated to a near record quarter in new issuance between January and March, with some bonds experiencing strong capital appreciation due to refinancing or as they were bought by investment grade companies. Performance is also helped by a steady income stream. Some high yield bond funds could produce income yields close to double digits ? significantly higher than bank interest rates – and anticipate a strong 2011.

When moving money out of cash into other investment assets you should aim to have a balanced portfolio which reflects your objectives, risk tolerance and investment time frame. You should discuss your situation with a wealth management firm like Blevins Franks to get personal recommendations.

By Bill Blevins, Managing DIrector, Blevins Franks

16th May 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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