UK interest rates could rise despite the Bank of England

There are few things that are less certain right now than the path of interest rates in the UK. That’s despite the Bank of England’s attempts to reassure investors that it will not raise its key interest rate anytime soon from the record low level of 0.5%. Even when it does, it will do so in a gradual manner, the central bank says.

The importance of the topic was revealed after the Bank’s last monetary policy meeting, when Governor Mark Carney refused to deliver a hawkish message. There were outraged howls from some borrowers who, afraid that the central bank would finally hint at putting up the rate, rushed to fix their mortgages, spending money on fees in the process.

But even though Carney disappointed them, their decision to fix may turn out to be the best bet. That’s because interest rates can move even if the Bank of England isn’t prepared to raise them.

If they do, the central bank can only follow suit. And, to try to get ahead of the curve, it would have to raise rates faster than it would have done if it had started already. This would be highly destabilising for a fragile economy like the UK’s.

How could interest rates increase without the Bank of England’s seal of approval? Put simply, market expectations could change.

The Bank of England has been behind the curve pretty much during the whole “recovery” from the Great Recession. Luckily, this didn’t seem to matter too much – the eurozone debt crisis was so deep and had so many bad turns, that the UK was attractive for investors by comparison; therefore it has been sheltered from a crisis of confidence. But things could change now.

The European Central Bank is printing money in earnest and even talks about expanding its quantitative easing programme. This is already boosting asset prices in the eurozone but also, crucially, seems to be improving lending to businesses to some extent.

If the eurozone becomes more attractive, investors would be less ready to forgive the UK economy’s imbalances. The biggest are: double deficits (current account deficit averaging 5.5% last year, and budget deficit, at 5% of GDP in the fiscal year that ended in April), and public debt at around 80% of GDP. That’s what a fast-growing emerging market looks like, not a developed economy advancing at around 2.5% a year.

Add to that a huge bubble in the housing market, which, if sentiment towards UK property reverses, could burst with incalculable damage.

The Bank of England has mentioned buy-to-let – in which landlords buy flats to let on, often with mortgages on which they only pay the interest, counting on house prices to keep rising in order to make enough profit to cover the principal at the end of the mortgage term – among the biggest risks to financial stability in the UK.

The figures presented in the central bank’s December stability report on the issue are staggering: since 2008, the stock of buy-to-let lending has increased at an average pace of 5.9% — almost 20 times faster than the growth in lending to owner occupiers.

In the third quarter of this year, buy-to-let lending increased by 10%, even after Chancellor George Osborne announced the gradual withdrawal of some tax relief on the payment of interest on mortgages. Then, last month, the chancellor announced an additional stamp duty of 3% on buy-to-let properties, in an attempt to rein in the sector’s unbalanced growth.

Add to this the fact that the UK is entering a period of turbulence, not just because of the shifts in the global economy but also because, ahead of a promised referendum on leaving the European Union, polls indicate that most people would vote to leave.

With so much uncertainty, investors in UK government bonds might decide they are no longer the safe haven they used to be. They could decide to sell, pushing up yields and therefore interest rates.

UK interest rates are below US ones but above eurozone rates. Source: Legal & General Investment Management.

UK interest rates are below US ones but above eurozone rates. Source: Legal & General Investment Management.

This trend could be exacerbated by the fact that some pension funds must move out of longer duration bonds towards shorter durations as the average age of their members increases, putting more upward pressure on yields at the longer end of the curve.

The Bank of England has gone to great lengths to promise low interest rates for a long time. But at the end of the day, the central bank does not control the market’s direction. It can, at best, hope to anticipate it.

1 thought on “UK interest rates could rise despite the Bank of England

  1. Pingback: In 2016, watch out for house price deflation - Market Moving News and Views

Comments are closed.