Why interest rates could rise this year

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.

However, with rates low for such a long time, the effect on spending levels has now lost much of its potency. Borrowers can only bring forward so much spending from their future, and before long many will choose to use the extra money to start paying down debts.

Meanwhile savers with a set goal in mind, say building up a deposit for a house, will combat low returns on savings by cutting spending further in order to make up the shortfall.

Despite this dwindling impact, interest rates have largely been low for such a prolonged period because economic indicators have remained subdued. The economy has become increasingly reliant on cheap money, and quantitative easing has proven difficult to unwind.

Why might continued high inflation trigger a rates rise? 

Interest rates are the main lever for keeping inflation within 1 per cent of the Bank of England’s 2 per cent target. And a number of factors are making it increasingly difficult for the bank’s Monetary Policy Committee (MPC) to sustain a ‘wait and see’ approach.

Source: Bank of England and Office for National Statistics. 20 years to June 2017.

With the exception of June’s result,  there has been a clear upward trend in inflation since late 2015, which accelerated after the Brexit vote, taking us to the highest rate for over five years in May.

The MPC inflation report forecasts that CPI will rise further above the target in the coming months peaking at a little below 3 per cent in the fourth quarter of the year before falling gradually.

The Bank’s sample of external forecasters also averages an inflation assumption of 2.8 per cent for 2018. If inflation above 2 per cent is prolonged, it could become embedded through underlying ‘cost push’ pressures, wage increases, and a government lacking political authority to control demand via fiscal policy.

In these circumstances, interest rates could rise materially over 2017-2020 to exceed the market expectations implied by the yield curve.

Will the UK follow the US?

The US Federal Reserve (Fed) has raised its central interest rate several times in recent months – it now sits at 1.0-1.25 per cent, and  is expected to increase it once more in 2017, and again in 2018.

This, coupled with accelerating global growth, will also put broader macro pressure on UK rates.

Source: Bank of England and www.federalreserve.gov/monetarypolicy/openmarket 20 years to June 2017

UK interest rates tend to broadly mirror those of the US over time. While certain events have caused more extreme reactions in one market compared to the other – such as the 2001 terrorist attacks, and subsequent military conflicts in Afghanistan and Iraq – the UK tends to follow a similar pattern to the US. 

With the US already raising rates three times in recent months, and potentially once more before the end of the year, we have another signal that the UK could soon follow suit.