FOOL'S EYE VIEW
Interest Rates On The Up

By James Carlisle
June 17, 2002

Earlier this month, the Bank of England's Monetary Policy Committee voted to keep the base interest rate at 4%. It's the lowest the base rate has been for 38 years and the eighth consecutive month that they've kept it there. Recently, though, there's been some muttering about interest rates starting to rise again. Should we be worried?

What they are

The first point to make is that there's more than one type of interest rate and you have to be very careful which you're talking about. They're defined by who's borrowing the money (and what kind of risk they represent) and over what period of time.

So you have short-term interest rates, which are basically for money lent 'overnight' and repayable immediately, then you have a 'one-year' interest rate, a 'five-year' interest rate, a 'thirty-year' interest rate and everything in between.

As far as pounds are concerned, the Government is the best credit risk there is since it's never failed to pay anyone back. No great surprise since it actually prints the money.

Why they matter

The interest rate that the Government pays sets the benchmark for the interest rates that everyone else pays on their borrowings and the returns everyone expects from their investments. We'll all have to pay a bit more to borrow money, depending on how risky we are and we'll all expect a bit more from our investments depending on how risky they are.

The two interest rates that matter most are the Government's 'short-term' interest rate, commonly called the base rate (currently 4%) and the Government's long-term interest rate, which is generally taken to be the yield on 30-year dated Government borrowing (in other words a 30-year 'gilt'), which is currently about 5%.

The short-term rate matters because it dictates what we'll pay for borrowing now, for example on a variable rate mortgage and, as the flip side to this, what we'll get for cash on deposit in a savings account.

The long-term interest rate matters because it determines what people will expect from their investments. So, with the current long-term interest rate set at about 5%, people might expect a risky share to produce a return for them of, say, 10% -- to make up for the risk. If the Government's long-term interest rate suddenly increased to 10%, then we could get our 10% return without taking any risk. We might therefore expect that same risky share to produce returns of 20%. Assuming we still expect that company to generate the same actual money, then we'd probably only pay half as much for its shares, so that the return became 20% instead of 10%.

The same goes, in fact, for all shares and property. If the long-term gilt yield goes up then, all things being equal, we'd expect share and property prices to drop by a similar proportion. If long-term interest rates fall, then you'd expect to see them rise. That's been very much a feature of the strong performance from shares and property over the last 30 years or so.

How they're set

For the proper functioning of the economy, interest rates need to be kept a little bit, generally around 2-3%, higher than inflation -- otherwise people would be losing money by putting it in the bank. The Bank of England's long-term goal is to keep inflation down at about 2.5% and thereby keep long-term interest rates at about 5%. It sets short-term interest rates to achieve this.

If the economy starts running ahead too strongly, potentially setting off a bout of inflation, then the base rate will go up to make it more expensive to raise money and thereby cool things down a little. If the economy grinds to a halt and inflation isn't a worry, then the base rate will be reduced to get things going again.

Since short-term interest rates are the tool that the Bank of England uses to keep long-term rates stable, it follows that the short-term interest rate is much more liable to change. After all, the Bank would be prepared to raise interest rates up to 10% or 15% to keep to its long-term inflation target of 2.5%.

What to expect

We can see what investors are expecting from interest rates by looking at the gilt market. The three-month gilt is only yielding 4.1%, so people are obviously not expecting much of an increase in base rates, from the current 4%, over the next three months. However, judging by the one-year gilt yield of 4.7%, the market is expecting increases of nearly 0.75% over the winter. From two years onwards up to thirty years (i.e. the long term), gilt yields are pretty steady at 5%.

Investors obviously think that the Bank of England has inflation under control and that long-term interest rates should remain steady at around the 5 per cent mark. To achieve this, though, the base rate probably needs to rise by about 0.7% over the next 12 months. Despite all the talk about rising interest rates, that doesn't sound too severe. Certainly nothing to get stressed about.

Allow for a base rate of double the market expectations

Of course the market isn't always right. Back in late 1999, the market was expecting interest rates to rise (from 5.5% at the time) to about 6% now to restrain the booming technology sector. As it's turned out, the tech sector restrained itself pretty convincingly without the need of any interest rate rises. In fact, short-term interest rates have been cut to 4% to give things a lift and keep the long-term rates at around 5% (in the US, the short-term rate has been cut more aggressively).

The market has been wrong about long-term interest rates before as well. Back in the inflationary seventies, 30-year gilts were yielding well over double today's level. But those were the days when political expedience was placed ahead of long-term economic stability. With the Bank of England now in charge of interest rates, we can hopefully look forward with some confidence to some long-term interest rate stability. At least that's the view the market seems to be taking.

All in all, then, there's probably good cause for resting fairly easily as far as the long-term interest rate is concerned and that's a comforting sign for share and property prices. Remember, though, that the Bank of England will raise interest rates to whatever level is necessary to achive this. As always, then, the most important thing is to keep your mortgage within very comfortable limits. The market is only expecting the base rate to rise to 5%, but you should be confident of maintaining your mortgage payments if interest rates rose to at least double that level. You can find out how that might affect your monthly payments by using the calculators in our Homeowning Centre.

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