“Mortgage rates may hit 14% within two years” – that was the headline in the Daily Telegraph’s respected Finance section on 23rd August 2010. Although we are still a few days away from this interest-rate Armageddon, it looks as though Money Facts, the “leading think tank” making this prediction, got it wildly wrong.
The Bank of England Base Rate is still stuck at 0.5%. There is even a real possibility, with inflation falling, of a further cut in the Base Rate to 0.25%. All this illustrates the difficulty in predicting future interest rates; a year ago everyone believed that whatever happened, rates could not go lower.
There is now a consensus that rates will not go up any time soon. We are part of this consensus. But we do not enjoy being part of the consensus – history shows it is often wrong.
So what are the possible scenarios where interest rates may go up?
Scenario 1: The economy recovers and the Bank of England gradually increases the rate to the level – around 5% – we were used to before 2007. Renowned economist Roger Bootle referred to this last week as the “pigs may fly” scenario. We are nowhere near a recovery; Governor of the Bank of England Mervyn King recently said that we are not even halfway through this crisis. The world economy seems to be sinking into a depression.
And even when a recovery finally comes, it will not be easy for the Bank of England to increase the Base Rate without causing mortgage misery for many households and a consequent fall in house prices.
Scenario 2: The Eurozone collapses leading to a big increase in interest rates. In this scenario Greece, Spain and Italy go bankrupt, Mrs Merkel is unable/unwilling to bail them out and a tsunami-wave of economic chaos hits the UK. The British economy may then become a target of the bond vigilantes as the Coalition’s deficit-reduction strategy would be in ruins, depending as it does on growth in the British economy. Interest rates may need to spike up to high levels.
Predicting market movements is difficult enough but predicting the actions of politicians is even harder. We would have to hope that common-sense prevails and Europe’s politicians avoid catastrophe. And if interest rates did spike up, it may be similar to what happened in 1939 on the outbreak of war, when the Bank of England Base Rate shot up but then fell back down shortly afterwards.
Scenario 3: Inflation engulfs us and interest rates go up. But right now inflation is falling with CPI down to 2.8%; deflation seems more likely in the short-term. The effects of the Government ‘printing’ more money (Quantitative Easing) are likely to lead to inflation in the long-term, as this money gets spent and demand for goods and services increases. But at the moment most financial institutions and individuals want to hoard cash or pay off debt, so the effects are not yet inflationary.
In the short-term inflation seems unlikely to push up the Base Rate. But in the medium to long-term some economists predict high inflation which we haven’t seen since the 1970’s and 80’s. This may be the only way for the US, Eurozone and British governments to escape their crippling debts – a slow and sneaky default where creditors are repaid in a devalued currency.
So in conclusion there is no economic recovery in sight and inflation seems a distant threat. We do not know for certain how the Euro-crisis will play out but whilst the politicians have not yet come up with a long-term solution, they have proved adept at kicking the can further down the street and avoiding meltdown.
Interest rates are therefore likely to remain low for the foreseeable future but we will remain vigilant.
David Bowker
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