What to do about interest rates and inflation?

Published on Saturday 13 February 2010 12:40

THE prediction from the Bank of England that interest rates and inflation will remain subdued for the coming year will have homebuyers dancing on their kitchen tables this weekend.

It's not such good news for savers though, who are more likely to be reaching for the brandy bottle. But what if it is wrong?

Consumer anxiety about the months ahead, particularly the prospect of tax rises following the general election, mean that pronouncements from the Old Lady of Threadneedle Street alter as well as forecast behaviour.

Homebuyers and savers use these forecasts to decide whether to fix their mortgages and savings, or stick with floating rates, for example. Others swing between saving or buying a big-ticket item before the price goes up again. So many will have listened carefully to the governor of the Bank of England, Mervyn King, when he gave the clearest indication yet that base rates will remain at a historic low of 0.5 per cent until the end of the year, silencing those predicting spring rises.

King also anticipates inflation, currently 2.9 per cent, will have risen above 3 per cent in January following the recent VAT hike and increase in petrol prices, but will then fall back to below 2 per cent and remain benign for the near future.

The economy, King says, is bumping along the bottom with a gradual recovery now looking firmly in prospect.

However, not everyone agrees with this analysis. Some critics wonder if the governor has gone soft on inflation, as part of a wider policy remit to inflate away part of UK debt obligations.

Simon Ward, chief economist of Henderson New Star, said: "A year ago when inflation was 3 per cent the Bank predicted it would fall back to 1.3 per cent in the first quarter of this year. It was wrong.

"What worries me with last week's predictions is that we have been here before. The Bank has consistently over-estimated the forces of deflation and under-estimated inflation."

The danger if interest rates stay low while inflation picks up, he says, is that the UK will be left with the lowest "real" interest rates among developed economies. This will make it difficult to attract overseas investment.

Ward added: "I don't believe inflation will fall below 2 per cent, particularly when you consider that, post an election, a new government will almost certainly raise indirect taxes such as VAT, which puts up prices.

"Neither am I convinced that fiscal tightening will choke off demand. Household savings have risen. If taxes go up, families will dip into their savings rather than reduce spending."

The point about inflation is that, if it were to remain stubborn, the Bank would ultimately have no alternative but to raise interest rates sooner than expected, unless it was deliberately abandoning its 2 per cent target.

When it comes to drawing up a financial strategy for the months ahead, consumers must consider the various possible scenarios, and decide for themselves whether a "low interest rate, low inflation" scenario is more likely; or whether we will see cheap borrowing but rising prices. Finally, the unhappiest ending of all, climbing inflation and interest rates, cannot be ruled out.

Below are some ways to cope.

Mortgage borrowers

Swap rates on which fixed-rate loans are based came down after the Bank's statement, with some lenders, such as the Yorkshire Building Society, launching new fixes. The Yorkshire's new two-year deal is as low as 3.09 per cent. HSBC is offering five-year fixes below 4.8 per cent.

Nevertheless, the expectation is that borrowers will do better if they stick with a base-rate tracker mortgage, which allows them to switch out without a penalty. The cheapest are offered by First Direct and Woolwich.

Charcol's Ray Boulger said: "The expectation has to be that rates will remain low for the time being. But at some stage they will rise.

"If you like the security of a fix, there isn't much point fixing for two or three years, because those deals could be coming to an end just as the cost of borrowing has taken off.

"I now believe there will be lower fixed deals in the next few months. We can't predict when rates will rise again, but if you stick with a tracker, you can switch into a fix before costs take off again."

However, Moneyfacts warns that the costs of mortgages are only coming down for borrowers with significant deposits.

Irrespective of base rates, lenders are widening their margins, particularly for higher risk loans.

Moneyfacts' Darren Cook said: "The average two-year fixed for a borrower with a 10 per cent deposit has increased steadily since April 2009, and is now 6.48 per cent. By comparison, the average rate for a borrower with a 25 per cent deposit is 4.27 per cent, the lowest level since July 2009."

Property market

House prices should continue to rise as long as interest rates remain low, according to most commentators.

The Centre for Economics and Business Research predicts that UK house prices should rise by 6 per cent this year.

This bullish view is shared by Henderson New Star's Simon Ward. He said: "The labour market will start getting better. If you have cash to put down, you will receive a higher return from property than by putting your money in the bank with interest rates where they are. Why wouldn't prices rise?"

Savings

If inflation remains subdued, then low interest, though painful, may not be a disaster for savers. As long as they secure a return of 3 per cent – difficult but possible – and minimise tax through an Isa, then they are still earning a real return of about 2 per cent.

However, if inflation remains stubborn at 3 per cent or higher, then the picture is quite different. Savers' money is not earning anything after rising prices are accounted for, and their buying power may actually fall.

There are better fixed rates available, of up to 5 per cent. However, with the prospect of higher interest to come, it may be unwise to lock into three- or five-year investments.

On the other hand, swap rates are falling (see Mortgages) which means fixed-rate savings returns could fall lower in the short term. Today's rates may be the best savers will see for a few months to come.

Bonds may be an alternative (see Page 8), but be aware that these can also devalue over time, if inflation gets out of control.

National Savings & Investment index-linked savings certificates may be an option for those concerned about inflation, as are index-linked gilts.

But the best protections against inflation are real assets such as property or shares.

Stock market

Simon Ward believes the UK economy will recover during the coming year, but says that, for investors, the biggest risk will be the falling pound. He said: "Companies are now global, even UK companies, so share prices should benefit from the worldwide recovery.

"I believe that UK investors will do best by concentrating on companies with strong overseas earnings, which will protect them against the falls in sterling."