Clock ticking on interest rate rise

BANK of England interest rate- setters announce their latest decision at midday on Thursday, and while rates will almost certainly be left on hold at this meeting, the Monetary Policy Committee is edging closer to sanctioning the first rise since the summer of 2007.

Last month’s meeting saw the first dissenting votes for higher interest rates, with two of the nine members voting for an increase from 0.5pc to 0.75pc.

I do not expect the first rise to materialise until February 2015, but the clock is now ticking.

Whether you are a mortgage borrower or saver, there are three key questions: when will interest rates rise?; how quickly will they go up?; and, where will they peak?

Despite the Bank’s much vaunted ‘forward guidance’ there is still considerable uncertainty as to when the first rate rise materialises.

Financial market expectations have swung around a lot over the summer, with the markets initially betting on the first hike coming this November, but subsequently pushing expectations back into spring 2015.

What we can glean from the Bank’s latest forecasts is that without a rise in interest rates in early 2015, policymakers expect inflation to overshoot its 2pc target next year. That is why my forecast is for February 2015.

Once the Bank pulls the trigger, it seems likely that interest rates will rise at a pedestrian pace – ‘limited and gradual’ in the words of governor Mark Carney, which we interpret as no more than 0.25pc each quarter during 2015.

So, if the first hike comes in February that would take rates up to 1.5pc by the end of next year.

Interest rates are likely to peak at a much lower level than in the past. During the last rate-raising cycle in 2006-07 – just before the financial crisis – the Bank’s policy rate peaked at 5.75pc. This time, we expect rates to have climbed to just 2.5pc or thereabouts by the end of 2017.

This will probably come as a relief to mortgage borrowers, but will obviously be much less welcome among hard-pressed savers.

There are two main reasons to expect such shallow interest rates rises: First, and most importantly, the mountain of household debt, the bulk of which is tied to floating interest rates, means relatively small rises in policy interest rates will have a powerful impact on debt servicing costs.

British households have made modest progress in reducing their debt since the financial crisis, but debt (mainly mortgages) remains way above historic norms.

With house price inflation running at double- digit rates on some measures a renewed buildup of debt looks likely.

By my estimates – taking into account expectations for income growth, house prices, mortgage borrowing – rises of just 1.5 percentage points (from 0.5pc to 2pc) would raise households’ debt- servicing costs to above long-run averages.

With the average mortgage just above £131,000, 1.5 percentage points of interest rate rises would increase mortgage interest payments by around £160 a month.

This is not a negligible increase for households facing a persistent income squeeze.

Second, the Government still has a great deal of work to do to reduce its budget deficit. Without this ‘fiscal tightening’ interest rates would have to rise further. Listening to much of the political and media commentary, you could be forgiven for thinking that the UK is engaged in a ‘slash and burn’ approach to the public finances.

The reality is more mundane. Progress has been made in reducing the UK’s deficit, but we are only at the halfway point.

When the Coalition came to office in 2010, the deficit stood at 11pc of GDP (the highest since the aftermath of the Second World War).

By the end of the 2013- 14 financial year it had been reduced to 6.6pc of GDP (the sort of levels which prevailed when Britain went ‘cap in hand’ to the IMF in 1976). Clearly, there is still some work to do.

THE UK has Scandinavian levels of public spending but existing tax structures that cannot fund this: in the jargon there is a large ‘structural deficit’.

The Coalition’s plans are for the deficit to be eliminated by 2019, almost entirely through public spending cuts.

Forecasting the elimination of the deficit is one thing. Delivering it is another.

And if these spending cuts are not delivered then eliminating the deficit will require higher taxes. Far from being a temporary aberration, the financial squeeze felt in recent years looks set to persist.