Why interest rates could rise this year

  • To understand why rates are so low.
  • To learn what might trigger a rate rise.
  • To ascertain what sort of investment strategy could help clients.
Why interest rates could rise this year

Inflation figures for June revealed an unexpected fall in the CPI rate to 2.6 per cent after seven months of rising rates and May’s high of 2.9 per cent.

The announcement led to speculation that inflation is now at – or is close to – its post-Brexit-vote peak, and that an interest rates rise could therefore be kicked into the long grass. 

The recent inflation dip was largely the result of falling oil prices, which offset rising food and import costs. However inflation remains above its 2 per cent target and only time will tell whether this result will be sustained or a blip in an otherwise upwards trend.

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We must be careful not to overstate the importance of one figure, and remain cognisant of the broader market environment and underlying trends.

Continued high inflation; increases to the Fed’s central rate; and the prospect of a ‘softer’ Brexit following the recent general election result, are all sound reasons why a rate rise could still occur later this year.

So while this relaxation of inflationary pressure certainly makes an interest rates rise at the next Monetary Policy Committee meeting unlikely, advisers should continue to prepare their clients’ investment portfolios for rates rise in the not-too-distant future.

A rise after such a sustained period of low rates would no doubt be heralded as a positive sign of economic health, but it presents new challenges, and new opportunities, for those owning investments whose valuations are linked with interest rates.  

Why have rates been so low for so long?

It was over eight years ago that the Bank of England first cut interest rates to 0.5 per cent. The credit crunch of 2009 thrust the UK banking system into a severe funding shortage, restricting its ability to lend.

With the credit taps all but turned off, consumer demand fell, house prices fell, and economic growth quickly followed suit. The Bank of England acted promptly to boost liquidity by cutting the bank rate, the interest rate at which the central bank lends money to domestic banks, and by injecting money into the economy through quantitative easing, the purchase of government bonds. 

Over the course of a year the UK the base rate tumbled from 5 per cent to settle at 0.5 per cent by March 2009, the lowest since the central bank was founded in 1694.

Rates then remained unchanged for seven and a half years, until August 2016, it was once again cut, this time to 0.25 per cent, to help shore up the anticipated economic fallout from the EU referendum.

Lower interest rates incentivise spending by making borrowing cheaper, and disincentivise saving through poorer returns; they aim to effectively move spending from the future to the present.

They also tend to increase the relative price of assets such as bonds, shares and property providing a boost to certain types of wealth, which encourages both business investment and spending by those who own such assets.