Does low inflation mean an interest rate rise is around the corner?

The Bank of England interest rate has been at its record low now for over 6 years, since it was reduced to 0.5% in March 2009. However, with recent news that UK inflation has once again dropped to 0% in June 2015, well below the Government’s target rate of 2%, it seems that a rate rise may now be on the horizon.

Mark Carney, the Governor of the Bank of England has recently warned that the sun may be setting on the long period of 0.5% borrowing costs. In a speech at Lincoln Cathedral Mr Carney is reported as saying “interest rate increases would proceed slowly and rise to a level in the medium term that is perhaps about half as high as historical averages. In my view, the decision as to when to start such a process of adjustment will likely come into sharper relief around the turn of this year”.

This move is driven at eliminating slack in the market to create the conditions for a sustainable increase in costs which are necessary to achieve the government’s target of overall inflation of 2%. This will be assisted naturally as price pressures emerge over the coming months when the fall in oil prices ceases to have a bearing on the cost of living.

An increase in inflation and interest rates obviously brings with it cost consequences for a nation of mortgage-based homeowners and their domestic balance sheets. However, there are crumbs of comfort which suggest the nature of the rise will be less painful than it might be.

On the basis of historical interest rate rises, the increased costs will trickle down gradually. When the Bank began to target inflation in 1992 borrowing costs increased by 0.5% every three months, whilst this time Mr Carney has described the rise as proceeding ‘slowly’ – indeed he has stated that he expects the rise to take place over the next 3 years. On top of that, he suggested that rates would peak at just over 2%, which represents half the historical norm since the bank was founded in 1694. A small crumb of comfort it may be, but in terms of historical context, the rises will be gentle and conservative.

Those recently enticed by long-term low rate tracker mortgages will be those most helpless in the face on base rate rises and will want to consider the costs of remortgaging. Mortgage lenders may also brace themselves for an increase in fixed rate mortgage applications amongst those whose fixed mortgage periods are coming to an end and see an opportunity to protect themselves against the rises, which are really anticipated to hit their peak and bite 18-24 months after the first rate rise, by locking themselves in for longer periods than they might in the past.

Whilst it is always good to try and be ahead of the curve, any shock to the economy is likely to affect the timing and scale of interest rate rises. At least for the time-being, a Greek shaped shock no longer appears imminent. Contact us.