Money is now 50% more expensive that it was a few years ago -- this affects the value of your shares in a variety of ways.
The timing of yesterday's rise in interest rates seems to have taken just about everyone by surprise. True, the Bank of England only increased the base rate by 0.25% to 5.25% which doesn't sound like much. However, money is now 50% more expensive than it was three and a half years ago when it bottomed out at 3.5%.
While many news reports have focused on the impact on mortgages, the effects on business and the economy are a little more complex.
Firstly, why the rate rise?
The Monetary Policy Committee of the Bank of England is charged with responsibility for hitting an inflation (CPI) target of 2%. This figure has recently crept up to 2.7%, combined with a strong economy, so the MPC thought it prudent to act sooner rather than later. Details of their deliberations will be released on January 24th.
At least in theory, the MPC's remit does not include controlling the performance of your investments in housing or shares -- asset inflation is not the same as consumer price inflation.
But why the imperative to control inflation?
When prices are increasing too rapidly, people and businesses feel the need to spend before prices rise more, thus driving prices even higher. Combine this with the inevitable demands for increased wages, which push up costs, and we get inflation spiraling out of control.
In that sort of environment, it would be very difficult for businesses or individuals to plan ahead. The thinking in recent years is to keep inflation low and nip it in the bud before it goes out of control. This is an economic target that we seem to be able to control with relative success, at least so far.
Higher interest rates reduce inflation in several ways:
- Making it more attractive to save rather than spend;
- Making it more expensive to borrow to spend;
- Reducing the disposable income of existing borrowers, especially mortgage holders;
- Increasing the value of the pound against other currencies, which makes imports and oil cheaper;
- If house prices fall, reducing the 'wealth effect' that causes people to spend more when their assets are appreciating and they feel richer.
Naturally, this affects our investments in shares:
- Lower spending means lower sales for many companies;
- It costs companies more to borrow;
- A stronger pound makes it more expensive to export and cheaper to import;
- Future cash flows are less valuable, as they must be discounted at a higher rate. Notice the trend for private equity to take over cash-generative utilities rather than more speculative investments;
- If investors can earn more money on deposit, then the return they require for investing in shares is also increased -- the price of shares falls so future returns are greater, all things being equal (which they rarely are).
While most of these immediate effects may be negative, many will consider them a small price to pay for maintaining a reasonable level of inflation, and preventing a boom/bust cycle. Despite an initial wobble when the increase was announced, the FTSE closed up over 1% on Thursday night.
More: Interest Rates And Repossessions Are Up! | Compare Mortgages At The Fool!
