Interest rates – trapped by history

March marked the 8th anniversary of the base rate in Britain at 0.5% or below.

Generation Y could be forgiven for thinking interest rates never move, while those of an older persuasion will remember when rates could jump as much as 3% in a single day with very little warning. The latter have been trapped by history and maintained their view that a base rate of 0.5% is an aberration and would soon rise – and have been wrong for eight years. Meanwhile, the former are in danger of nurturing a complacent belief that rates will remain low indefinitely.

It is remarkably easy to become trapped by your own investment history.

This is why a significant proportion of the older generation put their savings into cash and bonds come retirement. The anxiety felt on the realisation that it is not possible to live off the interest this generates is palpable.

Meanwhile, the young, or at least those that have successfully fought their way onto the housing ladder, often have little idea how much their mortgage could cost them if rates rise.

Many opt for the flexibility of a two-year fixed term – why bother with a longer fixed term if rates hardly vary – and take out the maximum mortgage they can afford. A rate rise of 2% over the next two years could mean they have to find at least another £180 a month when they come to re-mortgage; no mean feat when wages are expected to stay fairly static, or fall in real terms when inflation is taken into account.

A turning point?

The outlook for interest rates is therefore very important for generations at either end of the scale. As the Bank of England has increasingly wedged itself between a rock and a hard place it has been forgotten that the present level of interest rates were intended as an emergency measure.

Yet a turning point often occurs when all hope has been lost of anything ever changing. Maybe, just maybe, we are at that point now.

Economic news has improved, consumer spending is on the rise and financial assets are buoyant, which suggests an upward tick in interest rates could be warranted. Yet, debt has also risen and our ageing generation demands ever greater spending on healthcare and social services while itself contributing less and less to the central pot.

On top of this, a huge degree of uncertainty surrounds Brexit and the effect it will have on the UK’s economy. Finally, inflation is steadily climbing and currently sits at 2.3% - historically an indicator of an impending interest rate rise. However the Bank of England is often willing to ‘look through’ what it views as a temporary spike in inflation – remember it reached as high as 5% in 2012 with no move in interest rates.

Where will rates peak?

So, there are a number of political and economic forces opposing one another. Consequently, the older generation will remain disappointed as I do not expect a return to 5% interest rates for quite some time.

A significant rise would place too much pressure on borrowers and a recession would soon ensue – starting with the housing market. Conversely, I do not see rates remaining stationary for many more years either. The rate cut made shortly after Brexit was unwarranted and could be shortly reversed if economic growth is sustained; however, a ‘peak’ above 2% is unlikely in the current cycle.

2% might not seem like a lot, especially in the context of average rates in the 1980s. However, it would provide welcome relief to deposit holders and, with any luck, prompt mortgage holders to understand how rate rises affect their payments.

Getting to 2% though is likely to be a long, drawn out process – the Bank of England is in no rush.

source: https://www.hl.co.uk/news/articles/interest-rates-trapped-by-history