The Interest Rate Debate


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The news that UK inflation had risen even more than expected re-ignited the debate as to when the Bank of England (BoE) will increase its base interest rate. Since the traditional weapon to fight

The news that UK inflation had risen even more than expected re-ignited the debate as to when the Bank of England (BoE) will increase its base interest rate. Since the traditional weapon to fight high inflation is high interest rates, many then expected interest rates to rise sooner than expected, possibly in the spring. But it is not that simple and many experts urged the Monetary Policy Committee (MPC) not to give in to pressure to lift the base rate. Indeed a week later bad news about UK economic growth meant that expectations had to be revised again.

According to the Office for National Statistics, the Consumer Prices Index (CPI), the official measure of inflation, rose 3.7% in December, up from 3.3% in November. Economists had expected it to be 3.4%.

The cost of living has been driven up by the soaring cost of oil as well as food prices which are increasing due to demand and supply shortages. Oil prices are 20% more expensive than they were a year ago and agricultural commodity prices are almost 50% higher. The cost of basic commodities like wheat and cotton has been rising at its highest pace for two decades.

The BoE has an inflation target of 2%, but it has been at least 1% higher than this for a whole year now. The January VAT increase was not included in the December figure, and BoE governor Mervyn King has now warned that inflation is likely to rise to between 4% and 5% over the next few months.

With the base interest rate just 0.5%, British savers are earning a negative real return on their savings. Using figures from the Moneynet website, the Telegraph calculated that higher rate taxpayers now need an interest rate of 6.17% so as not to lose money once inflation and tax are taken into account. Basic rate taxpayers need 4.63%, yet there is only one account currently paying above 4.63%.

The Telegraph also reported that, using Moneyfacts data, British savers have lost out on around ?60 billion in interest since the BoE cut the base rate to 0.5%.

The rate has been held at 0.5% for 22 consecutive months, over which time the average variable savings rate was just 0.77%. During the previous 22 months it was 3.41%. Taking into account the country?s total savings balance and compound interest, savers earned ?58 billion less in the last 22 months compared to the previous 22.

So when will rates rise? This is a much debated topic and predictions have been changing from one month to the next. In December the general view was that rates would rise once in the last quarter of this year. In mid January some traders began factoring in three rises in 2011 but after the news that the UK economy had shrunk by 0.5% in the last quarter of 2010 any interest rate rise is likely to be delayed, possibly for another year.

While the BoE is concerned about the ?uncomfortably high inflation?, the latest economic data does rather justify their stance on interest rates. Speaking on 25th January, King said that the MPC could not have prevented the squeeze on living standards by raising interest rates. He warned that the Bank ?neither can, nor should try to, prevent the squeeze in living standards?. He explained that if the Bank had increased interest rates, any drop in inflation would have been the result of a slower economic recovery and higher unemployment, and so ?the erosion of living standards would have been even greater?.

He admitted that savers and ?those who behaved prudently? would be among the ?biggest losers? from the crisis.

After the inflation data was released some experts had urged the BoE to continue to keep rates on hold.

The Ernst & Young Item Club has urged the MPC to keep the base rate at 0.5%. ?It is vital that the MPC stands firm. A premature rate rise would boost the pound, weakening the UK?s ability to increase its exports ? particularly to the emerging markets ? which we have long maintained hold the key to the UK?s economic recovery.?

The Evening Standard columnist, Anthony Hilton, argued that provided inflation remains below 5% it should actually help the UK economic recovery as it gives the UK an edge over other economies with lower inflation, and suggested that inflation ?can be the least painful solution? to the government?s record debt. Inflation running at 4% would reduce the overall debt burden by almost 25% in five years and almost halve it within nine years.

He pointed out that while it makes sense to use interest rates to cool inflation caused by an over buoyant market, this time inflation is caused by the rise in global oil and food prices and VAT increases. Raising UK interest rates would not prevent this and would just make life harder for the economy as a whole.

There is a counter argument to this, with Roger Bootle of Capital Economics saying that the MPC could still try to offset higher commodity prices by bringing down other prices.

However Bootle said that wages will be the key factor. If workers force up pay to maintain real living standards then we would see a sustained general inflation and the BoE may have to act. But if pay does not rise faster inflation will subside and the Bank can hold still. So far there is no sign of a response from pay and he expects this to continue.

As he said on 14th January, ?I stand by my long-held view that interest rates will be 1% or lower for years to come?.

The Bank of England does not have an easy task ahead of it, and looks like it will be some time before rates return to ?normal? levels. If you would like to consider your options for income or capital growth, and get peace of mind that you are keeping pace with inflation, speak to an experienced wealth manager such as Blevins Franks.

By Bill Blevins, Managing Director, Blevins Franks

26th January 2011

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