Are you ready for an interest rate rise?
Date published: 31 October 2017
Lucy Warwick-Ching, James Pickford and Josephine Cumbo
Britain’s first interest rate rise in more than a decade looks to be imminent after inflation hit its highest level in five years and the governor of the Bank of England said it had further to climb.
Mark Carney warned MPs a few weeks ago that it was “more likely than not” that prices would increase further in October and November. His comments came after official data showed consumer prices rose 3 per cent in the year to September, from the previous month’s 2.9 per cent rate. The rise, which took inflation to its highest level since March 2012, was driven largely by increasing food and transport prices.
If it had risen further, Mr Carney would have had to write to Philip Hammond, the chancellor, explaining why inflation is more than 1 percentage point above the central bank’s 2 per cent target and what to do about it.
Higher inflation makes it more likely that the BoE will raise interest rates from its record low of 0.25 per cent when its Monetary Policy Committee meets next month.
A rise would help bolster the weakened pound, but would also push up borrowing costs — with immediate implications for millions on floating-rate mortgages — and could run the risk of choking off growth at a time when economic activity is already weakening due to uncertainty over Brexit.
How likely is a November rate rise?
The base rate has been at 0.25 per cent since August 2016 and has not risen at all since July 2007. Last month, Mr Carney said he expected a rate rise “in the relatively near term”. And this week’s labour market data — which revealed that wages are continuing to rise at a slower rate than prices — is adding to the growing pressure to raise rates in November, say analysts.
But a November rise is not set in stone. Even as inflation rose, some MPC members expressed doubts to MPs about the need for an increase. Dave Ramsden, deputy governor for markets and banking, and Silvana Tenreyro, an external member, were sceptical about the need for imminent tightening. It seems the vote in the MPC meeting on November 1 could be tighter than previously thought.
How quickly could rates go up?
Given market sentiment, Mr Carney will need to take action soon, says Calum Bennie, a savings specialist at Scottish Friendly.
“Interest rates have to rise to help tackle inflation and the sooner this happens, the better,” he says. “Mr Carney must recognise the wolves are now at the door and take action to strengthen the pound, even though this may increase mortgage costs. Consumers have been dealt a double blow of poor income growth and rising shop prices over the past year. For many, this has increased dependency on credit, but with defaults now on the rise it is clear that many families are finding it nigh on impossible to balance the books.”
Kallum Pickering at investment bank Berenberg predicts rates will rise by 25 basis points in November with a further three 25bp rises before the end of 2019, with two in 2018 and one in 2019.
However, others predict that the BoE will be wary of the fragile state of the UK consumer as it considers its next move.
“On one hand, the BoE doesn’t want to heap pressure on borrowers by raising rates, potentially slowing economic growth from an already glacial pace,” says Laith Khalaf, senior analyst at Hargreaves Lansdown. “On the other hand, consumer borrowing is rising at quite a clip, and inflation is also heading in the wrong direction, both of which suggest a rate rise is in order.”
He concludes that the Bank of England is “caught between a rock and a hard place”. Markets have bought into the hawkish rhetoric emanating from the central bank of late, and are now pricing in a rate rise before the end of this year.
“The BoE does have form for disappointing spectators on this front, however looking beyond a potential rate increase in the next few months, the longer term picture is still one of low interest rates dominating the economic landscape for some time to come,” he adds.
How are mortgage lenders responding?
Rates on mortgage deals have been plumbing record lows in the past two years as base rates have been held at 0.25 per cent. But many lenders’ fixed rates have ticked up in recent weeks after a rise in swap rates, which lenders use to price their home loans.
HSBC last week raised interest rates on some of its 2, 3 and 5-year fixed-rate home loans by up to 0.2 percentage points. This follows increases by Barclays, NatWest, Nationwide and Santander.
Those already tied in to a fixed-rate deal will see no change in their monthly repayments if base rates rise in November. But millions on tracker mortgages or standard variable-rate mortgages — which are typically higher than fixed-rate deals — could see their loan costs rise before Christmas.
Aaron Strutt, product manager at Trinity Financial, says: “In the past, lenders have put rates up and brought them down again. We wonder if we’ve reached the point where they won’t come back down.”
David Hollingworth, director at broker L&C Mortgages, says more borrowers are likely to focus on longer-term deals. “We will see more people questioning whether this is the turnabout for interest rates and whether they can lock in for medium-term rates. There will be quite a bit of interest in the five-year rates,” he predicts.
The extra costs of a 0.25 percentage point rise in mortgage interest will not be onerous for most. A borrower with a £200,000 25-year term mortgage paying a standard variable rate of 4.5 per cent would see their annual repayments rise by £330 a year if the rate rose to 4.75 per cent.
The most likely effect will be borrowers rushing to fix, as lenders withdraw their best deals. In the past two weeks, for instance, two-year fixed-rate deals below 1 per cent have disappeared from the market. “[A rate rise] will start to lead to people taking action,” says Mr Hollingworth.
Lindsay Cook, the FT’s Money Mentor columnist, warns that it could take several months for any new mortgage deal to be processed. “If you are on a floating rate and are thinking of remortgaging, start getting your paperwork in order now before rates rise,” she advises.
Will savings rates increase?
The average interest on savings accounts has been gradually ticking up from record lows, according to the latest data from Moneyfacts, the consumer data site, which revealed that the rates on fixed rate individual savings accounts (Isas) rose faster than any other savings product this month — with the average one-year cash Isa up 0.04 per cent to 1.04 per cent.
However, the Moneyfacts data reveals there is still not a single standard savings account that beats, or even matches, the current 3 per cent rate of inflation.
“Positive news is hard to come by in the savings market, but rate increases outweighing cuts for yet another month is exactly that,” says Charlotte Nelson, finance expert at Moneyfacts.
“Where previously the rate increases were concentrated on the fixed rate savings market, September saw the start of an easy access revival as many providers made noticeable increases to their easy access accounts.”
In September, the average increase in rates on easy access savings accounts was 0.34 per cent, according to Moneyfacts — the largest monthly increase in the past year.
There are several current accounts that offer better interest rates as a switching incentive, but these tend to be for fixed periods and on a limited amount of cash.
Is it better to invest my money in the stock market?
Low wages and high inflation mean we need our savings to work even harder to generate an inflation-beating return.
Maike Currie, investment director for personal investing at Fidelity International, says stock markets offer the best chance of generating a real return in the long term.
Calculations from Fidelity show that if you had invested £15,000 into the FTSE All-Share index 10 years ago, you would have amassed £26,273 (factoring in the reinvestment of dividends). By contrast, putting £15,000 into the average UK savings account over the same period would have generated just £15,604.
In real terms, your cash savings would have gone backwards — allowing for inflation, £15,000 10 years ago would be the equivalent of almost £20,000 today, according to the Bank of England’s inflation calculator.
How should I change my investment strategy?
Investing in the stock market can provide protection against inflation. Provided that inflation does not increase to a level which prompts an extreme interest rate rise, experts say gently rising prices can often be favourably exploited by companies.
Inflation also bodes well for highly geared companies. As debt tends to be fixed, a business’s borrowings will be eroded as inflation takes off. Fidelity’s Ms Currie says that even with no change in the overall enterprise value of a company, all investors need is for the balance to move from debt to equity to make a significant gain.
Experts say investors should be wary of investing in retail stocks in times of high inflation, because they may struggle to pass on price rises to consumers. Instead, investors should consider investing in companies and funds with high exposure to international earnings.
Darius McDermott, managing director of Chelsea Financial Services, advises investors to seek overseas exposure.
“With the UK economy and currency looking a little shaky, investors could benefit from increasing their overseas exposure,” he says. Two actively managed funds that he recommends are the M&G Global Dividend Fund and the Scottish Mortgage Investment Trust. “The latter has the added attraction that it has increased its dividends each year for the past 34 years,” he says.
Should I adjust my portfolio for higher interest rates?
According to Seven Investment Management (7IM), which publishes fund purchases in every quarter, many investment managers are already preparing client portfolios for potential interest rate rises.
Gilts, and to a lesser degree corporate bonds look particularly vulnerable to rising inflation. This is because they pay a fixed rate of income that buys less as inflation eats into it.
“The inclusion of two short dated bond funds in the top 10 [of fund purchases for this quarter] is interesting — advisers are clearly looking to protect investors from potential interest rate rises,” Tony Lawrence, an investment manager at 7IM says. “Short dated bonds are a low risk, albeit lower return, approach to fixed income investing.”
Others say alternative assets such as infrastructure and commercial property can offer good inflation protection as the income these assets produce is typically linked to inflation, and will rise accordingly.
What about my pension?
Inflation can often be bad news for pensioners as it will erode any cash savings, says Tom McPhail, head of policy at Hargreaves Lansdown, the investment manager. However, this week’s well-timed inflation rise will trigger a relatively generous increase for both private and state pensions.
Millions of pensioners will see their state pension payments rise by up to 3 per cent from next April thanks to the “triple lock” which guarantees the benefit will rise by the higher of September’s inflation figure, average earnings or 2.5 per cent.
The new state pension, which came into force from April 2016, is likely to increase by nearly £5 per week from its current £159.50 to £164.50 for those who can claim the full amount.
The basic state pension, payable to those who reached pension age before April 2016, is likely to rise by £3.80 a week from £122.30 to £126.10. The government will confirm the exact level of pension rises next month.
The rise in consumer price inflation will also affect millions of retired public sector workers, including teachers, doctors and nurses, who will also see their pensions increase by 3 per cent next year.
Furthermore, retired private sector workers, whose defined benefit pensions are linked to the retail prices index, will see bigger increases to their income than those in the public sector, whose pensions are linked to CPI.
According to the ONS, the RPI was 3.9 per cent in September. About two-thirds of the UK’s 6,000 defined benefit pension schemes currently use the RPI to calculate annual increases for pensioners.
The pensions lifetime allowance (LTA) will also rise by £30,000 to £1.03m from April next year. This is because increases in the LTA are also linked to CPI.
The LTA governs how big a pension pot can grow over a lifetime while benefiting from tax relief. Any savings above the lifetime threshold, when the pension is eventually drawn, will attract a higher tax charge.
People with pension savings above the current lifetime allowance of £1m who have not taken out available tax protections could see a cut of up to £16,500 in excess tax charges, plus a £7,500 increase to the amount of tax-free cash they can take, according to Hargreaves Lansdown.
What effect will the Budget have?
There is a good chance the first interest rate rise in a decade will occur weeks before the chancellor’s first autumn Budget on November 22, increasing the political pressure to help those who are “just about managing” as real incomes are squeezed.
Speculation is mounting that Philip Hammond will unveil bold policies to tackle the surge in support for Labour among younger voters.
A potential way of doing this could be to offer tax cuts targeted at younger voters, for example reducing their national insurance contributions, or cutting interest rates on student loans (which are linked to inflation). Speculation is rife that to fund such policies, the chancellor could raid pensions tax relief.
However, should interest rates rise as expected, many debt-laden youngsters could find themselves struggling under increasing financial pressure, says Gary Smith, chartered financial planner at Tilney.
“Many young people simply can’t afford to save much into pensions in their early years, as they use their income to fund a property purchase and mortgage costs, raise a family, and repay student loans,” he says.
“It is typical for people to increase their pensions funding in later years once they have the excess financial resources to do so, but any reduction to how much can be contributed could restrict this type of planning.
“Ultimately, I do feel that changes to the pension tax relief system are inevitable at some point, but there are other ways to achieve this without penalising older savers in favour of young people.”
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