What’s Next For Interest Rates

interest ratesBrexit has meant many changes to the financial climate – and not least to the outlook for interest rates. A few months ago, most pundits were confidently predicting the next change would be a move up from the current record low of 0.5%, where it has been since March 2009 during the last recession.

The nine strong group Monetary Policy Committee (MPC) who decide the appropriate level for the bank’s main interest rate, also known as base rate or Bank Rate had planned to raise interest rates, probably before 2017.

But the economic outlook for the UK has changed. The Bank of England was widely expected to reduce its base rate in July to help the UK economy cope with the negative impact of the shock Brexit vote. Such a move could help to stave off a recession.

In the event, it didn’t happen, perhaps because a change in Prime Minister and Chancellor was already making the economy even harder to predict. But the Bank of England is widely expected to cut rates next month, to a miniscule 0.25%. The decision could have implications for your ability to get a mortgage, as well as your savings and pension.

Why cut?

Last month’s referendum result has meant uncertainty centred on the UK’s trading relationships. Uncertainty affects economic activity, and it is feared that Britain could fall back into a recession. It could take month or years to know for certain, but policymakers prefer to act in advance of a downturn, rather than after one has begun. With rates already so low, there is not much scope to slash them further – but that is what the MPC look set to decide to do.

What will it achieve?

The basic economic logic of rate cuts by a central bank is to boost demand in the economy by encouraging businesses to invest and consumers to borrow and spend.

Commercial banks park their money at the Bank of England, and earn a small rate of interest for doing so. Cuts to the Bank Rate would make this even less attractive, and make other options more appealing. So, commercial banks might prefer to make their money work harder, by investing it or lending it out. This increases the supply of money in the economy, hopefully decreasing the chances of recession.

Of course, there is a downside. Sterling fell in value against the US dollar and the euro after the EU referendum vote, and has moved lower in anticipation of an interest rate cut. This makes exports more competitive, but imports more costly. That latter factor is expected to lead to higher inflation, as households have to pay more in sterling for foreign goods and services.

Some economists believe that inflation could rise above the Bank’s 2% target next year as a result of this. Cutting interest rates, weakening the pound further, could mean an even larger overshoot of that target.

What does this mean to you?

Traditionally, cuts in interest rates by the Bank of England were associated with lower monthly mortgage repayments by families as lenders passed on the cut in their funding costs to their borrowers.

Mortgage borrowers certainly received a major financial windfall after the Bank rapidly slashed rates from 5 per cent in October 2008 to 0.5% in March 2009 during the last recession. People with tracker mortgages – where the interest rate goes up and down with the Bank Rate – will benefit.

Someone with a 25 year £250,000 repayment tracker mortgage paying 2% interest would see their monthly £1,100 repayment fall by around £30 if rates went down by 0.25%. But tracker mortgages are less common than they were, and with rates already low, lenders may not pass them on at all on other types of mortgage.

It will mean even lower returns on cash savings. The amount banks pay to cash savers has fallen in step with the official base rate, meaning savers have been getting very meagre returns for the best part of seven years.

Average interest rates on instant access savings accounts are currently just 0.4%. Cash ISAs pay out just 0.82%, and we can expect these to fall further still – but with interest rates already so low banks may instead choose to absorb the hit themselves in the form of lower profits.

However, rate cuts are not all bad news. They tend to boost asset prices, such as shares and bonds. Investing accordingly could be a sound tactic.

If you want to make sure your own economic outlook can remain positive, even with falling interest rates, contact the Continuum team.

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