Whither interest rates?

Simon Whittaker, Finance Director, offers his prediction on the future of interest rates in the UK.

Today’s announcement that CPI inflation is now down to 0.3% p.a. – with forecasts that this could turn negative in the spring – will doubtless cause some commentators to predict that Bank Rate will need to be cut further (or even taken negative as has happened most recently in Denmark and Switzerland) to prevent DEFLATION.

It’s funny how just 18 months ago with unemployment falling below 7% (it is now 5.8% and still falling) these same commentators were predicting an early increase in rates. Now with inflation dropping an irrational phobia is creating paroxysms of panic that everything needs to be done to avoid DEFLATION – and so we need further interest rate cuts and/or more QE to prevent this.

But I believe the logic is fatally flawed. Let me explain by way of example.

I have just bought some new tyres for my car. I bought them because the old tyres needed replacing – and I did not delay buying them just because I hoped they might be cheaper next week. But the simple fact is that identical tyres from the same supplier cost me £150 each whereas in January 2014 they cost £180. Nobody in this country is worse off (other than the Chancellor of the Exchequer) as a result of this price drop – it has occurred due to reduced cost of raw materials that were bought overseas. And I am left with cash to spend on going out to a restaurant – thereby stimulating the economy, creating more jobs and potentially creating conditions where an increase in interest rates is required.

So there are many commodities for which buying habits are not determined by anticipation of future price changes. This should be obvious – otherwise the electronics industry would never sell anything – but there is an almost irrational fear of DEFLATION which drives the pronouncements of most public commentators many of whom are predicting that any rise in Bank Rate is at least 18 months away. I fear that such a delay would most likely lead the economy to “overheat” drastically and that the need to control this could lead to a much sharper increase in interest rates than is currently foreseen.

Some may remember that I predicted an increase in rates in the run up to the Election – clearly this won’t happen now – even if the economic fundamentals indicate that such a rise might be the right thing to do in the long term interest of the economy. But I continue to have great faith in the current Governor of the Bank of England and believe that he will act far earlier than many (including our Sales Director – Steve Olejnik) expect. I believe that this would be in the long term interests of investors – so look for a rise in the autumn...

Just one final point. Swap rates for 5 and 10 years bottomed out at the end of January and have now bounced by around 0.25% - with smaller increases in the shorter term swaps. Such a big jump can ultimately only lead to one thing – an increase in the cost of fixed rate products. No pressure yet because swap rates are still below where they were in December, but further increases would put pressure on the pricing of 5 year fixed rate products.

>> Comparing 5 year fixed pricing

>> Current SWAP rates

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