Despite voting 7-2 to maintain the base rate at 0.25 per cent during its September meeting, the Monetary Policy Committee has, as expected, raised interest rates from 0.25 per cent to 0.5 per cent.
The dichotomy between weak growth and elevated inflation provided a dilemma for policymakers at the Bank of England – whether to raise interest rates in order to bring inflation down towards its 2 per cent target or to maintain its former accommodative stance to help stimulate growth.
Initial estimates suggest the UK economy grew 0.4 per cent during the third quarter, following growth of 0.3 per cent during the second quarter and 0.2 per cent during the first, considerably slower than the upgraded Q4 2016 figure of 0.7 per cent.
- The Bank of England chose to raise interest rates early in November.
- Newly issued bonds will offer investors a higher return.
- The implications for equities are likely to be negative.
The case for an interest rate rise was very much premised on the assumption that the output gap, which represents the difference between current output and potential output, is now smaller, with spare capacity within the economy being absorbed quicker than anticipated.
An unemployment level of 4.3 per cent in the three months leading up to July has been suggested as evidence of this, with some economists believing that this level is at, or below, the natural equilibrium level of full employment.
Inflation remains heightened; the consumer price index (CPI) rose to 3.0 per cent during September, well above its target of 2.0 per cent and just below the level at which the governor of the Bank of England has to write an open letter to the chancellor explaining why the level has deviated from its target.
This is likely to remain elevated going forward. The Bank of England, as set out in the August Inflation Report, has forecast that the CPI will remain above the 2 per cent target up to mid-2020, as currency-induced cost pressures continue to exert their influence on the price level.
What will the interest rate rise mean for investors?
For some asset classes, movements in interest rates have direct effects; in others the implications are a lot less explicit.
In an environment where interest rates are rising, we can expect the value of fixed income securities to decline; there is a direct inverse relationship between interest rates and prices.
In such an environment, newly issued bonds will offer investors a higher return than those currently trading on the secondary market. As such, the prices for these outstanding bonds will decline as the demand becomes depressed when investors naturally veer towards the securities offering a higher return. In addition, those bonds with longer maturities, such as those to which pension schemes are often highly exposed, are more vulnerable to changes in interest rates and so price changes are amplified.
Increased borrowing costs are also likely to have a negative impact on mortgages, with interest expenses increasing for those on variable and base rate tracker contracts. This is likely to have a knock-on effect on the wider property market as expensive mortgages will depress house prices due to lower demand.