HOW soon are interest rates likely to rise? And how high might they go?
Such is the pace of recovery and the continuing falls in unemployment that millions of homeowners with a mortgage or businesses planning expansion now need to factor in higher interest rates over the next two years. And if history is any guide, an initial hike in rates is more often followed by a series of rises. Today’s emergency level of 0.5 per cent could be up to 4 per cent or higher sooner than most realise.
That could prove traumatic for many who have taken advantage of the lowest level of official interest rates for 300 years to step up their borrowings. That, after all, was the point: to help the economy off the floor by encouraging households and businesses to spend and to lower the rewards of saving. To help matters further, the government launched its Help to Buy scheme to boost mortgage lending and speed up a housing recovery. Now there are fears of a house price bubble forming in London and the South-east.
As a rough guide, a three percentage point rise in a £100,000 repayment mortgage over 25 years would lift monthly payments from £590 to £779. Many borrowers have taken advantage of low (2 to 3 per cent) two or five-year fixed rate offers. These are likely to be the earliest to be affected, with rates already beginning to creep up.
The Bank of England’s authoritative Inflation Report last week came with clear signals that a sea change is under way on interest rate expectations after an unprecedented four years of official rates held down at an ultra-low 0.5 per cent.
The economy is now recovering at a faster pace than the Bank reckoned in the summer. Its Monetary Policy Committee has again raised its growth forecasts. Its base case is for real GDP growth of 3.4 per cent next year and 2.8 per cent in 2015, against 2.7 per cent and 2.4 per cent previously.
Unemployment has continued to fall and is now at 7.6 per cent, its lowest since early 2009 and inching closer to the 7 per cent trigger level at which Bank governor Mark Carney has indicated that rates would start to rise. Business confidence surveys are markedly upbeat and private sector hiring intentions continue to be positive.
All this has presented the Bank with a double problem. The first is the question mark it has put over its own credibility. The second is that it may have set course to sail into a political wrangle.
Back in the summer, Carney unveiled his new policy of “forward guidance” to help give households and businesses a better idea of the interest rate outlook.
Well, that was the plan. He said rates would remain at their emergency level until unemployment broke below 7 per cent. And that, according to the MPC, was unlikely to happen much before the third quarter of 2016.
But within weeks this forward guidance began to unravel. The view in the markets was that the recovery was stronger than Carney had envisaged, that the 7 per cent trigger level would be reached much sooner, and as a result interest rate expectations would shift. Seldom has an official initiative to predict and control rates unravelled so quickly. “Forward guidance” has proved to be little better than the tapping of a blind man’s stick. And it has brought no clarity – least of all certainty – as to when rates might be changed.
However, the broader news has been good – perhaps too good to last. With growth picking up more strongly and forward indicators such as Purchasing Managers’ Index surveys for services and manufacturing pointing to continuing improvement, the MPC now expects the jobless rate will fall to the 7 per cent threshold around the end of 2014 – two years earlier than it thought just a few months ago.
The question now is how quickly the Bank might act if we do hit this earlier projection. This would suggest a rise in rates, quite possibly the first in a series, in the first quarter of 2015.
But this coincides with the approach of the Westminster general election. And, by convention, the central bank has sought to avoid movements in rates during such a politically sensitive period.
The Bank, of course, is now independent and may pay no attention to the political calendar. But an important consideration here is whether the combination of a rate change together with heightened political uncertainty may impact on business and household confidence and impair the recovery. In that event the pressure would be on Chancellor George Osborne to respond to the latest “cost of living” threat posed by higher rates with tax cuts.
A related issue – on which forward guidance has, perhaps mercifully, not sought to opine – is how quickly interest rates may rise to a level more akin to that normally seen at this stage and at this pace of recovery. This is thought to be around 4 per cent. Carney’s predecessor Sir Mervyn King did warn borrowers of the prospect of a series of relatively quick rises that could pose problems for those seduced into extra debt during the period of emergency rates.
The market expectation is that a rising interest rate cycle will begin in 2015 and that it is likely to be gradual and extended. One factor that should help to constrain a rapid move to 4 per cent rates is the benign inflation outlook. The MPC has sharply revised down its inflation forecasts and believes that it will fall to 2.2 per cent in the current quarter, against an earlier forecast of 2.9 per cent. And even with the higher growth outlook it expects CPI inflation will be a little below the 2 per cent target two to three years ahead.
That suggests a more benign and gentle rise in rates. But in the light of the failure of “forward guidance” punditry, it is as well to keep in mind the possibility of a more rapid increase. This would be the case were business investment to recover more strongly and GDP growth to be higher than the MPC expects.
There is no easy exit route or one that avoids dislocation and trauma. Adopting emergency measures such as quantitative easing and rock-bottom interest rates was always the easy part. Weaning us off four years of monetary methadone will prove altogether more tricky.