Interest Rate Rise – the Implications

On 2nd November, the Bank of England’s Monetary Policy Committee (MPC) took the decision to raise the official lending rate for the first time in a decade. The new rate has been set at 0.5%.

For many years, the country had operated at historically low rates of interest and August last year saw the base rate reach a record 0.25%. However as the Bank itself had recently been anxious to signal, this wasn’t a rate that could last.

The new increase is only small, and that’s an important point. The BoE has stated that further rises will come, but that they will be slow and incremental. This reflects the considerable economic uncertainty that remains within the British economy, and an awareness that any big rise could constrain growth at a time when growth is badly needed.

The economic balance:

In economic terms, the justification for a rate rise is that it should help to control rising inflation. In essence, raising the cost of borrowing limits the supply of money within the economy and this has a braking effect on prices overall. When shoppers and businesses feel a financial squeeze, their spending tends to fall and so, in the face of greater price sensitivity, it becomes harder for vendors to raise the price of their goods and services.

Lately, inflation has been rising at over 3% – well ahead of the Bank’s 2% target – and the MPC has an obligation to control it. Currently, however, it’s being driven by an unusual force. Since the Brexit vote, Sterling has lost considerable value against other currencies, largely because foreign buyers believe that  a departure from Europe will have an adverse effect on the country’s economy. The falling value of the Pound makes it more expensive to buy from overseas suppliers and thus, the cost of everything from basic foodstuffs to industrial components has risen markedly.

In part, the rate rise is a response to this inflation problem, but there are those who argue that it can only ever be a blunt tool. Interest rate controls might be effective when inflation is the result of an overheating economy – when growth and rising incomes encourage excessive spending – but in this case, the pressure is external; the result of poor exchange rates and the low value of the Pound. In reality, say the critics, economic growth is very slow – Britain is now the worst-performing member of the G7 – and average real incomes have actually been falling. (Average annual wage growth currently stands at 2.1%, while the cost of living has risen by 3.2%.)

The Monetary Policy Committee has previously conceded that interest rate changes can only have a limited effect on inflation and, even in this latest MPC vote, two of the nine members voted against the increase. A possible reason for their reluctance is that raising the cost of borrowing could discourage businesses from investing in growth, so it could have a damaging effect on an already shaky economy.

As ever, the Bank of England is having to walk a difficult tightrope. However, with such a balancing act to perform, it will be unwilling to take risks. As the MPC has stated, investors can expect any further  movements to be slow and small. To put that in more concrete terms, many financial analysts expect the Bank to make  two additional quarter percent adjustments over the next three years, taking the base rate to 1%.

The investor perspective:

A higher base rate will affect different groups in different ways. For example, the UK’s 45 million savers should benefit if banks and building societies pass on the increase in the form of better returns on savings accounts. Those buying pension annuities also stand to gain.

However, for those who rely on borrowing – be they individuals or businesses – there will be added costs to face. Businesses that absorb these costs may see their profits fall. Alternatively, they may simply pass them on – raising their own prices and thereby contributing to further inflationary pressure.

The group most obviously impacted by the decision will be householders with a mortgage. A little over 8 million UK residents currently have a mortgage but, of these, more than half have taken advantage of fixed rate offers. They, of course, will not see any immediate change in costs. For the remaining 46%, the new rate will raise average mortgage repayment costs by an estimated £12 per month.

Landlords with a BTL mortgage will be similarly affected. Those with fixed-rate deals will see no cost increase until such time as the fixed rate period expires. For some, that might be a matter of months; for others, it could be a year or more.

Eventually, however, investors can expect mortgage costs to rise. These are often passed on in the form of higher rentals so it is ultimately the tenant who pays. Of course, landlords must judge whether the market will support a rise in prices. Market demand will depend partly on how the same economic changes affect ordinary paying tenants.

Those who rent rather than buy a home will not be worrying about the rising cost of mortgages, and those with savings in the bank might welcome a small hike in the interest they earn. In these respects, a higher base rate will have a negligible effect on tenants. However, those who borrow in other ways – via credit cards, store credit, car loans and so on – will undoubtedly see their costs rise. How that affects their ability to maintain rental payments will vary from one individual to the next, so it pays for landlords to understand their tenants and maintain effective dialogue.

A sense of perspective:

The bottom line for investors is that a higher base rate means higher costs, at least in the long term, but those costs needn’t necessarily translate into poorer annual returns. Moreover, the base rate is only rising by a quarter of one percent, so this isn’t a change that should shake the BTL sector to its core. It’s a modest change, carefully weighted to address certain inflationary pressures without doing undue damage to a faltering economy.

What’s more, lenders are still enormously keen to support the BTL sector, which represents one of their largest and most reliable markets. To that end, they continue to offer very attractive, fixed rate mortgages that enable investors to know exactly what their repayments will be for a defined period. There is therefore very little uncertainty to be faced, and while further base rate rises are forecast, the MPC is keen to emphasise that they will be increased at “a gradual pace and to a limited extent”.

Looking ahead:

Much of the current economic uncertainty relates to Brexit. The Bank of England reports that it is having a “noticeable impact” on the country’s economic performance and its immediate prospects for growth. It is the associated uncertainty that is weighing down the value of sterling, and thus fuelling higher prices across the country. Lacklustre business investment can be attributed to much the same cause. However, it’s important to recognise that the UK is in the very midst of that uncertainty; in other words, we are now seeing the problem at its worst.

Sooner or later, issues will be resolved, policies will be formulated, new trading terms will be established and, inevitably, that uncertainty will diminish. The country will find a new equilibrium and it will move on. When that happens, external inflationary pressures should ease, reducing the need for further rate rises, and there is every reason to believe that economic performance will revive.

While explaining its rationale for the base rate rise, the BoE pointed (guardedly) to certain grounds for optimism. Unemployment is low, it expects real wages to rise “gradually” over the course of next year, and it also expects to see stronger economic growth than previously predicted. In its announcement, it raised its 2017 growth forecast from 1.3% to 1.5% and said that it expected to see growth of around 1.7% in every successive year to 2020.

Summary:

This was a modest change to the base rate and the Bank of England had been careful to signal it in advance. It took no one by surprise and its effects should be relatively modest. For investors with BTL mortgages, it will inevitably see costs rise but its significance should not be overestimated. There are still many excellent mortgage deals on offer – still at exceptionally low fixed rates – and despite today’s change, Britain looks set to remain a low-interest economy for many years to come.

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