Interest rates – how high will they go? 

The latest 0.5% increase in Bank of England Base rate may come as a nasty surprise to some mortgage borrowers, but to be honest it has been flagged by the authorities for some time. The bigger question is, with inflation now forecast to hit at least 13% later this year, where are interest rates headed?

In the 1970s and 80s, inflation and the fortunes of the economy went through many cycles, and inflation hit 24% at one point and for most of the time between 1970 and 1990 was over 5%. Monetarist economic theory suggests that managing interest rates is the principle tool to manage inflation. The higher the inflation rate, the higher interest rates should be to dampen demand in the economy.

Since the mid ‘90s, inflation dropped to around 2% fairly consistently, and interest rates dropped with it, onwards to all-time lows for the last 14 years. We have all become accustomed to this, and these low interests have been “normalised” within our economy, – and those economies of most other industrialised nations. So hence, the latest increase to 1.75% seems shocking. But interest rates during the 1970s and 80s hit 15% or more on a number of occasions!

The authorities always have a juggling act when considering the correct interest rate, and no more so than currently. An over-heating economy (demand outstripping supply for many goods and services) and inflation are big concerns. This is tempered by the desire to avoid a major recession and force many people into financial difficulties. Further complicating the picture are the issues of the Ukraine war, Brexit supply issues, and inflationary energy costs. The government no doubt also has an eye on the cost of government borrowing which, with high borrowing rates, could spiral out of control. Forecasts are constantly being revised (eg inflation expectation now revised upwards by at least 3%).

So hence the authorities are treading carefully. However, there is no doubt that if the interest rates are set too low now, then problems will become more entrenched and even greater pain is likely later.

One “global” view we look to is the cost of a fixed interest rate for periods from two years to 10 years. This is, if you like, a collective view of many operators in the financial markets and perhaps is the bet reflection of where the markets expect rates to go. The “Swap Rates”** (the underlying rate used by lenders to fix rates) are trading at c. 2.75% for a two year fix, c.2.4% for a five year fix and c. 2.2% for a 10 year fix. These rates are suggesting a peak of variable rates in the next year or so and then falling thereafter. The actual rates seen are also a reflection of where the market thinks base rates might be headed. So perhaps a base rate high of c. 2.75%, or 1% more than current base rate.

This is all well and good and not too alarming, but keep in mind a few points. Firstly, these swap rates have been rising steadily over recent days, weeks and months, the trend is firmly up. Secondly, the Bank of England projections for inflation keep increasing and we might not be finished yet with this trend. And thirdly and perhaps most importantly, many parties are assuming (hoping?) that inflation will not become too entrenched in the economy. This happens when inflation expectations lead to workers demands for higher pay (at or near inflation rates) and this in turn pushes up the cost of products and services. There are already signs of this happening, and if it does then interest rates will need to be pushed up even more to combat the inflationary cycle.

The optimists would say that energy costs are a big contributor (they are) and that the costs will come back down in 2023 as Europe weans itself off Russian energy supplies – leading to a reduction in inflation. Our view is that Russia wants to create economic disruption in the West, and we will see more hikes to energy costs this winter as the Russians seek to maximise leverage in the cold months. And what will it cost to find other supplies? Of course a resolution of the war might unravel this issue.

So in summary, hopefully those rates being seen in the “Swap” market will be a good reflection of the heights that rates will reach, but there are many uncertainties. An increase in rates to 5% or more would not be a surprise. If you are borrowing money, then a fixed rate or other interest rate management products must be a serious consideration at the moment.

**note that the swap rates are the prices a lender will pay for a rate to underlie their fixed rate offerings. Please note that lenders will generally add a margin to this swap rate, representing their profit when lending money to you.

The views expressed in this article are a personal view of the author and should not be used as advice for your particular circumstances. The advice of a competent professional should always be sought before deciding on your interest rate policy.

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