FOOL'S EYE VIEW
Fool's Guide to Interest Rates

By Stuart Watson (TMFTiger)
September 12, 2002

Every month you might have noticed the financial markets get into a tizz as they wait for the latest decision on interest rates. But why are these announcements considered so important and how do they really affect you?

How rates are set

Altering interest rates is currently the most popular way for the developed countries to control their economy. More specifically they are used to keep the rate of inflation at a low level and within a narrow band, as this is perceived to be the most healthy for the economy overall as builds confidence and facilities long-term planning.

In the UK rates used to be set by the Government but, in 1998, the power to control interest rates was passed over to the Bank of England's Monetary Policy Committee (MPC). The Government still retains some influences over the economy by setting tax rates. If it is deemed in the national interest the Government does have power to instruct the bank for a limited period.

The interest rate the MPC sets (known as the 'base rate') is the rate at which it lends to other financial institutions, who in turn lend money to corporations and to individuals likes ourselves. The level of interest rates influences the amounts we borrow (or save) and therefore influences demand for goods and services. If there is less demand, prices should fall, as should the rate of inflation. (For a more detailed view, here is the MPC's explanation - pdf file).

The MPC is mandated to use interest rates to meet the Government's inflation target. Currently this is 2.5% and the MPC has to report to the Government should inflation be more than 1% higher or lower than this target. However, in terms of managing the economy, interest rates are somewhat of a blunt tool.  It can take up to 18 months for the full effect of a change to take place. So the MPC is constantly looking forward and seeing what changes will be needed to keep inflation at or around the 2.5% level.

At noon on the first Thursday of each month (occasionally the second Thursday), the MPC announces whether rates are to go up, down or stay the same. Often changes are expressed in terms of basis points. A basis point is one-hundredth of a percentage point, so 25 basis points simply means 0.25% and so on.

The MPC has nine members and publishes minutes of each meeting two weeks after they take place. These give more details about how they came to their decision and the split of the vote. Members of the MPC favouring a rate rise are known as "hawks". Those that vote for a decline are referred to as "doves".

What will happen to rates in the future?

Base rates are at their lowest level for some 40 years. (This link has details of base rate movements since 1970). However, they did reach a toe-curling 15% in both 1976 and 1982. So does this mean the only way is up? Or are rates expected to remain low for the foreseeable future? Although no one knows what the future holds, the gilt market provides a good guide of what the market expects to happen.

Gilts are essentially loans to the government (there is more about them in this article). The prices for gilts due to be repaid on certain dates give an indication on what rates are expected to be over that time period. You can find gilt rates in most broadsheets and on Bloomberg's web site. As you can see, people are not expecting rates to increase by much at all, even over the next 30 years! Of course, it's impossible to make these sort of predictions that far ahead, but the predicted rates for the next couple of years are usually reasonable close to the mark.

How do rates affect you?

For the majority, the most obvious impact is their mortgage rate. The standard variable rates charged by mortgage lenders are typically somewhere between 1% and 2% higher than the base rate. Changes in the base rate are usually reflected on a like-for-like basis, so a 0.25% increase in the base rate usually means a 0.25% increase in mortgage rates. A similar process happens with savings rates as well. Of course banks and building societies are quick to pass on changes in their favour and somewhat slower to pass on those that are not!

Most changes in interest rates are expected though. So, to a large extent, they are already priced into products like fixed rate mortgages and fixed period savings bonds. Rather than panicking about changes as they happen it makes far more sense to see what the current expectations are for interest rates in the next few years. Then you can assess whether your finances can cope. For example, how comfortably could you handle a 2% rise or more in mortgage rates?

As far as investments go, although the announcement of changes can cause lurches in one direction or another the effect is normally quite short term and soon gets swallowed up into the bigger picture of valuation and the general prospects for the economy. Buying or selling investments based upon what might happen to interest rates is pretty pointless.

In closing then, although much in the way of column inches and airtime is taken up by the 'will they, won't they' shenanigans regarding rate changes, the implications for Joe and Jane Public of the decisions themselves is quite small. It most cases rates will probably change by the amount the market expects, it's just that they change a little bit sooner or later. All you really need is a big picture view of what rates are expected to do in the next few years. Like all economic data, excessive analysis is soon subject the law of diminishing returns.

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