Interest rates could hit 8% by 2012
Interest rates could hit 8% in just two years’ time, as the Bank of England will be forced to employ rate hikes in order to tame rising inflation, according to Policy Exchange, an influential think tank.
Its chief economist, Andrew Lilico said that the £200 billion of cash pumped into the economy during the height of the financial crisis – known as quantitative easing – would lead to a “huge expansion of money supply which will lead to inflation”.
This, in turn, would put pressure on the Bank of England to raise rates to as high as 8% - levels not seen since the last recession of the early 1990s.
While higher interest rates could bring healthier offerings in the savings sector, it is likely to spell disaster for the country’s borrowers – many of who are already stretched to the limit after the last recession.
Homeowners are first to the chopping block. According to financial data provider Moneyfacts, a base rate of 8% could result in average mortgage costs of up to 14% after lenders have built in their own profit margins.
These margins would be even greater than they are now (mortgage rates currently average 4% against a current base rate of 0.5%) to offset the added risk of homeowners defaulting on their loans.
Priced at 14% a £200,000 repayment mortgage taken over 25 years would cost just under £1,000 extra each month than at today’s typical level of 4%.
A hike of that magnitude to the monthly budget would be simply impossible for most homeowners to absorb, according to Darren Cook, spokesperson for Moneyfacts.
“We don’t think the Bank of England will put interest rates up to 8% as it knows that the country was just fall over. Even if rates returned to more normal levels of 4% or 5%, many homeowners would struggle – not everyone has used the surplus cash from sustained rates of 0.5% to pay off their mortgages.”
Only one of the nine members of the Monetary Policy Committee, which decides on movements in the base rate, voted for a hike of up to 0.75% August.
But inflation is already higher than it should be. The consumer prices index measure of inflation stood at 3.1% in July against the government target of 2%.
A “traditional” mortgage, where the monthly repayments entail of repaying the capital amount borrowed as well as the accrued interest, so that during the loan period the capital debt is gradually paid off so by the end of the term the mortgage has been fully repaid. One advantage of a repayment mortgage is that it removes the risk of having a parallel investment (such as an endowment policy or pension), the performance of which is dependent on the stockmarket, such as with an interest-only mortgage.
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.
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).
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.
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.