Where Next For Interest Rates?


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As expected, the Bank of England (BoE) voted to keep the base interest rate at 0.5% at its January meeting. The rate has been held at this historic low since last March, a situation which has lef

As expected, the Bank of England (BoE) voted to keep the base interest rate at 0.5% at its January meeting. The rate has been held at this historic low since last March, a situation which has left savers earning negligible income. Many will have been earning negative real rates of return after inflation has been factored in.

Rates are expected to remain at very low levels for the medium to long term.

After the UK economy had failed to improve as expected, in December a poll of leading economists carried out by Reuters suggested that the Bank will wait until October before increasing the interest rate. Other experts warned that we may not see an improvement until 2011.

Roger Bootle, managing director of Capital Economics, at the time said that ?my money is on the Bank rate staying at 1% or lower for five years?. A forecast by the Centre for Economics and Business Research (CEBR) was marginally better, concluding that the rate would stay under 2% until 2014.

UK economic data to be released at the end of January is expected to show a return to growth over the final quarter of 2009, but many experts remain cautious over the prospects for interest rates.

Speaking prior to the BoE January meeting, Bootle repeated his forecast that the rate could stay under 1% through to 2015, adding, ?it wouldn?t surprise me if they are at 0.5% for five years?.

While economic growth will return this year, it is likely to be slow and drawn out. The BoE will want to avoid the possibility of a double dip recession and is likely to wait until it has seen a sustained recovery before putting interest rates up.

One major headache for the next UK government will be to reduce the huge budget deficit, likely to be attempted through both spending cuts and tax increases. As Bootle explained, ?a prolonged period of low interest rates will be required to allow the economy to withstand the looming fiscal austerity?.

One factor that may or may not bring forward an increase in interest rates is inflation.

Following the BoE?s January meeting one analyst, Simon Ward of Henderson New Star, said there was potential for an increase as soon as February as the Bank moves to ward off inflation.

However, the Bank?s short-term projections are that while inflationary pressures will increase this year, they will only be temporary, so it will not necessarily feel the need to increase interest rates at this stage.

In any case, if interest rates rise by a small amount after inflation has risen, the real return from savings accounts will not actually improve. It may in fact be worse if the increase in your cost of living is larger than the interest rate rise.

In the longer term, the potential for a surge in inflation remains, as a result of the fiscal stimulus packages. Interest rates are however not the only tool available to policymakers ? we cannot rule out a return to the Keynesian practice of increasing taxes and reducing government spending as a means of reducing money supply and cooling inflation.

While we can hope that the Bank does increase its base rate earlier than October, any moves upward will only be marginal ? the rate is unlikely to climb as quickly as it fell.

The European Central Bank (ECB) base rate is also on hold at 1%. Many economists expect it to remain unchanged throughout the year, with just a small increase in December.

The Eurozone recession formerly ended last year, but retail sales are still deteriorating, public sector borrowing is still contracting and unemployment has hit a record 10%. The economy is also dogged by the perilous state of Greece?s public finances.

When it comes to the savings rates offered by high street banks, last year savers benefited from competition between banks to offer the best rates to attract more people to deposit savings with them. The credit crunch had made it difficult for institutions to borrow money from the money markets and at the same time they were required to build up their reserves.

This year the situation has improved for the banks and they are able to return to traditional ways of raising funds. There is less need for them to try to offer a better rate than their competitors, so as long as the central bank base rate stays on hold, high street banks are not likely to increase the rates currently on offer.

Bank deposit accounts are however not the only way to earn interest. Corporate bonds, for example, also provide regular interest at a level that is normally higher than bank interest rates, particularly in the current environment. While unlike with a bank account the capital value can both rise and fall, this does create opportunities to earn a profit on top of the interest income and interest will continue to be paid even if capital values fall.

If you have had enough of the low bank interest rates on offer, speak to an experienced wealth manager like Blevins Franks for advice on how to earn an improved return from your capital.

By Bill Bevins, Managing Director, Blevins Franks

11th January 2010

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