CPD Courses  

What could higher interest rates mean for your clients?

  • Understand why central banks cut or raise interest rates.
  • Learn about the impact this could have on asset prices.
  • Understand how the pandemic has altered the way markets may view higher interest rates.

If an economy is growing at persistently below this level, then there is said to be an output gap, and the traditional response is to cut interest rates and increase government spending, to drive the growth rate towards trend. 

If the economy is growing at above the long-term trend rate of growth, then the output gap is said to be positive, and the likelihood is that inflation will soon rise.

The challenge faced by policymakers as the UK economy emerges from the pandemic is that lockdowns caused the rate of growth to collapse, as a huge number of businesses were unable to produce any output. This created an economy growing at far below its trend rate, and in fact experiencing significant negative growth.

The reopening of the economy caused a rapid closing of the output gap, though official figures show the economy remains smaller now than in the final quarter of 2019, despite growth of more than 4 per cent in 2021. 

The rapid closing of the output gap has been accompanied by a rise in the rate of inflation.

So, the dilemma for policymakers is whether to interpret the higher inflation as a problem, and put rates up, or continue to focus on the fact the economy is likely to be below its trend growth rate, implying rates should remain where they are.

The pandemic has introduced at least two variables into the policymakers calculations. The first is that either Brexit or the shift to remote working means the trend rate of growth in future may be lower than it was in the past. This would mean the output gap may be smaller now than would have been expected.

Remote working means many people are spending less on travel and other costs than in the past, which could permanently lessen economic output in some parts of the country. 

The second variable is that, highly unusually for a recovery from recession, household savings in the UK are very high. Hugh Gimber, market strategist at JP Morgan Asset Management, estimates household savings presently amount to about 10 per cent of GDP. 

As these are spent, inflation and growth should rise, but it would be a temporary effect, and contributes to the BoE’s present view that the inflation in the system is “transitory” in nature, reducing the need for interest rates to rise. 

Peter Toogood, chief investment officer at Embark Group, is dismissive of the impact of the higher savings rate on the economic data. He says most of those who have built up savings are higher earners, who have a lower propensity to spend, while lower earners, who have a higher propensity to spend, have been hit financially. 

With this in mind, he does not believe growth in the real economy will rise substantially, necessitating an increase in rates.