Where next for interest rates?
Before the economic downturn, few people paid much attention to the base rate - the official rate of interest set by the Bank of England's Monetary Policy Committee (MPC). Despite the group of economists meeting each month to discuss and vote on whether the rate should rise, fall or stay the same, the outcome rarely made much of an impression - it certainly was very rarely front page news.
But since October 2008, when the MPC first starting to aggressively cut the base rate, the story has become a lot more interesting. We've seen the base rate fall from 5% to just 0.5% - an all-time historical low. At the same time, many tracker mortgage borrowers have been reaping the benefits, while variable-rate savers have seen their interest rates fall.
The fact that the Bank of England has frozen the base rate for April and May shouldn't come as a huge surprise - after all, as the rate can't turn negative, it didn't have much scope for another cut.
At the same time, the latest inflation figures show that one measure of the cost of living, known as the Retail Prices Index (RPI), turned negative in March for the first time since 1960. It is now -0.4%, down from 0% in February.
The Consumer Prices Index (CPI) – the official measure of inflation that, unlike the RPI, does not include mortgage interest payments – also fell in March to 2.9%, down from 3.2% in February and 3% in January.
When inflation is high or rising, the Bank of England tends to increase the base rate to cool spending, as it becomes more expensive to borrow. When it falls, the base rate should also reduce - however, at the moment this is unlikely to happen as it cannot turn negative and there is little room for further cuts.
Some experts believe that inflation will rise in the months ahead, largely as a result of quantitative easing measures (the Bank of England increasing the amount of money in supply).
Alongside deciding to hold the base rate in May, the Bank of England also announced that it will increase the supply of new money by £50 billion to £125 billion.
But other experts argue that deflation (where prices fall rather than rise) is on the cards.
Charles Davis, economist at the Centre for Economic Business Research, says: “Inflation is likely to reach its lowest level since monthly data began in 1949 in the coming months.”
Stick or twist?
A recent Moneywise poll revealed that 69% of users expect the base rate to be between 0.5% and 2% by the end of the year.
However, 15% believe the Bank of England will increase the rate to between 2% and 4%, compared to 12% who think it will cut the rate to less than 0.5%. A further 1% of users think the base rate could rise beyond 6% by the end of the current year.
The truth is, without the aid of a crystal ball, it’s hard to know exactly where the base rate is heading. Much depends on inflation, and until the economists that make up the MPC get a clearer picture of whether this is increasing or slowing, the interest rate is far from set in stone.
As well as waiting to see what happens to inflation, the Bank of England is also likely to be waiting to see more evidence of the impact of monetary measures already taken.
The central bank says quantitative easing will take three months to take effect.
Adrian Coles, director-general of the Building Society Association, says: “With the general economic outlook remaining bleak, we hope that the expansion of the quantitative easing programme will help to lessen the severity of the downturn.”
Official figures from the Bank of England reveal that rates on instant access, notice and fixed-rate accounts saw a slight uplift in March – but remain depressingly low.
Instant access deals, for example, now pay on average 0.19%, up from 0.16%. However, this is still a far cry from the average rates seen last March of 2.47%.
Fixed-rate deals have also become slightly more competitive, with average deals now paying 2.65%, up 0.02% from February. Again, however, they pay significantly less than last year, when average rates were around the 5% mark. Notice accounts, meanwhile, remained stagnant at 17% between February and March – down from 3.42% last year.
Despite the slight uplift on fixed and variable-rate accounts, cash ISA savers have little cause for celebration – rates actually fell in March, from 0.96% the previous month to just 0.63%. This means that in the past year, rates on cash ISAs are down a whopping 4.18%.
Savers have been hit particularly hard by the rapid decrease in the base rate. According to data provider Defaqto, 60% of instant access savings accounts now pay less than 0.5% on a £1,000 balance - and 50% pay less than 0.25%.
As a result, people's savings are now barely able to keep up with inflation, and could even be eroding in value rather than growing. James Caldwel, director of Fairinvestment.co.uk, says pensioners are the worst hit.
"This time last year, pensioners were enjoying interest rates on their savings that were 10 times what they are now, when the base interest rate stood at 5% - now the average no-notice savings account has a rate of just 0.65%," he adds.
Low interest rates are also bad for banks and building societies. Coles explans: “While hard-pressed savers should see interest rates maintained, this decision does nothing to help lenders to attract new deposits that could be used to fund mortgage lending."
While some tracker mortgage borrowers have benefited from the falling base rate, lenders like Nationwide have 'collars' in place which prevent rates from falling below a certain level. So, with each base rate cut, fewer borrowers have benefited.
At the same time, people with fixed-rate mortgage deals have seen no change to their monthly repayments. Those on their lenders' Standard Variable Rate may also have seen no change, as many lenders have chosen not to pass on the base rate cuts in full - if at all.
New mortgage deals, however, are cheaper but only for people with big deposits to put down. Figures from data provider Moneyfacts show that two-thirds of mortgages currently on the market require buyers to put up a deposit of at least 25%.
However, if you’ve got your eye on a best-buy mortgage deal, then you’ll need to stump up at least 40% upfront.
The decision to freeze the base rate in April won't benefit borrowers - but it is also unlikely to make things tougher for them either.
However, Andrew Montlake, director of independent mortgage broker Coreco, is concerned that when the base rate does start to go up again (as it inevitably will) borrowers with loans that track the base rate will get a shock.
"There is growing concern that inflationary pressures will ignite a series of sharp rate hikes later this year and on into 2010," he explains. "With house prices still likely to be low when rates do start to rise, many homeowners will be at the mercy of higher interest rates without being able to remortgage because of insufficient, or negative, equity."
Monetary Policy Committee
A committee designated by the Bank of England to regulate interest rates for the UK. The MPC attempts to keep the economy stable, and maintain the inflation target set by the government and aims to set rates with a view to keeping inflation at a certain level, and avoiding deflation. The MPC meets on the first Thursday of each month and discusses a variety of economics issues and constitutes nine members: the governor, the two deputy governors, the Bank’s chief economist, the executive director for markets and four external members appointed directly by the Chancellor.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
With a tracker mortgage, the interest you pay is an agreed percentage above the Bank of England’s base rate. As the base rate rises and falls, your tracker will track these changes, and so rise and fall accordingly. If your tracker mortgage is Bank of England base rate +1% and the base rate is 5.75%, you will be paying 6.75%. Tracker rates are lower than lender’s standard variable rate (SVR) and as they are simple products for lenders to design, they usually come with lower fees than other mortgage schemes.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
This is the opposite of inflation and refers to a decrease in the price of goods, services and raw materials. Economically, deflation is bad news: the only major period of deflation happened in the 1920s and 1930s in the Great Depression. Not to be confused with disinflation, which is a slowing down in the rate of price increases. When governments raise interest rates to reduce inflation this is often (wrongly) described as deflationary but is really an attempt to introduce an element of disinflation.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.