Interest Rates

June 06

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I was at a meeting with a corporate client the other week and one of their staff members came out with a line that surprised me...

... interest rates are going to go up later in the year...

Quite how the staff member in question knew this was not clear to me!

The UK Base Rate is set by the Monetary Policy Committee (MPC) of the Bank of England. The Bank of England was, until a few years ago, controlled by the Government, but Gordon Brown made it fully independant. It now has a mandate to control overall levels of inflation within the economy, and is not so subject to a knee-jerk political agenda.

Unlike central banks in some other countries, the MPC does NOT publish what it is going to do in avdance. Instead, the MPC meets monthly, and takes a vote on what to do with base rates, and any changes come into affect immediately.

As such, talk about what is going to happen is at best speculation, and at worst wishful thinking.

What has changed is that the MPC have adopted a subtly different approach over the last 24 months or so. In the past they would only publish the minutes of their meetings, and avoid speculation on what might happen.

In the last couple of years, the so-called soft approach has taken hold. Bank Officials are more willing to make statements about what they would need to do if does not change.

So, anyone who says that they KNOW what is going to happen to interest rates is, well, wrong!

The something, however, brings me to the second important point about interest rates. They are a broad tool which affects everything in the economy.

If interest rates go up, it puts downwards pressure on house prices (because mortgages cost more), downward pressure on consumer spending (because credit card bills cost more), but upward pressure on the strength of Sterling...

... when UK interest rates are higher, overseas investors can get a better return by depositing their money in the UK, so buy more pounds, selling Euros / Dollars / Dirhams / Whatever.

As more people want to buy pounds, the exchange rate changes so that a pound buys more Euros / Dollars / etc.

This is good for folk who live in Britain and want to buy goods imported from overseas, since it now costs fewer pounds to buy a 100-dollar item.

This is, however, bad for folk who work in Britain and want to sell their goods and services to people overseas (ie exporters). They find it harder to compete against overseas companies since their cost bases are typically set in Sterling. (Very few UK employees have a Euro or dollar salary, for example.)

So, if moving the interest rates has a complex knock on effect in many areas, the MPC does not do it lightly.

House prices are one area among many which must be taken into account, but the myth that the MPC sets interest rates to manage house prices is only slightly true...

I happen to believe that, at some point later this year, there WILL be a small move upwards.... but I strongly caution you to give my opinion in this matter next to no weighting!

The question for the investor is what can be done to protect against upwards moves. The answer is, of course, fixed rate mortgages. While the rate you have to pay now is slightly higher than a variable rate, you can lock in your payments for a fixed term - typically 2,3 or 5 years though longer fixed rates are available.

The downside of a fixed rate mortgage is, of course, that if interest rates go DOWN, then you are locked in to the higher rate. There is no free ride, after all.

Which you should do depends, of course, on your personal circumstances, and is another reason why you should find a good Indpendant Financial Advisor (IFA).

However, if your IFA tells you that they KNOW that interest rates are GOING TO GO UP (or, for that matter, down), then I would suggest that you run away, fast.

This is just the feature article from the June 06 newsletter. Subscribe for market comment, forthcoming events, and more.

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