When you look at the long-term and short-term Bank of England base rate graphs, it is akin to night and day. Since the 2008 US mortgage crisis (and the more recent pandemic), the Bank of England has been under massive pressure to maintain historically low rates to support the economy. There was also an enormous liquidity crisis within the banking sector in the immediate aftermath of the US mortgage crisis and the resulting worldwide recession.
Several emergency monetary policies were introduced to avoid a complete collapse, including a multibillion-pound asset for liquidity swap with the Bank of England. However, while these short-term actions supported the UK banking industry, the long-term challenges are only emerging. As of April 2022, the UK base rate stands at 0.75%, with rampant inflation currently at 7% and fears it could hit double digits in 2022.
So, what are the long-term implications for the UK economy and, as a consequence, UK interest rates in 2022?
UK economic outlook
To appreciate the short to medium-term direction of interest rates, it is crucial to recognise how they influence economic growth. In simple terms:-
- When economies are struggling, interest rates tend to fall, reducing the cost of finance and encouraging a borrow and invest mindset.
- When economies are overheating, interest rates tend to rise, increasing the cost of finance and discouraging a borrowing and investment mindset.
There is a robust correlation between base rates and everyday interest rates, such as:-
- Fixed mortgage rates
- Variable mortgage rates
- Credit cards
- Loan repayments
While forecasting economic growth in the short to medium term can be challenging at the best of times, it is akin to rolling the dice and taking a chance in the current environment. For example, in February, the Bank of England was forced to slash its economic growth forecast for 2022. Expectations were adjusted downwards from 5% to 3.75%. In addition, we have recently seen the ongoing conflict in Ukraine and the knock-on effect on energy costs and global economic growth.
In a worst-case scenario, PricewaterhouseCoopers believe that UK GDP growth in 2022 could be as low as 2.8% or as high as 3.8%. Short to medium-term growth will be impacted by:-
- Commodity prices
- Disruption of supplies
- Financial contagion
- Lower trade
- Reduced investment flows
On the flip side, inflation has strengthened dramatically over the last six months and is now a genuine concern for the Bank of England. The Monetary Policy Committee (MPC) meets regularly to discuss monetary policy and is currently facing inflation at levels not seen for 30 years!
Even though the Consumer Price Index (CPI) is the favoured measure of inflation, the Consumer Price Index, including Housing costs (CPIH) and the Owner Occupiers Housing costs (OOH), are alternative measures of inflation. While the Bank of England has a CPI rate target of 2%, the rate is currently 7%, with even the optimistic Bank of England forecasting an 8% peak in the latter part of 2022. In all likelihood, we could see a short-term double-digit spike in inflation which won’t come down significantly until 2023.
This then prompts the question, if UK economic growth is falling and inflation is rising, what are the options regarding base rates?
What are the chances of further interest rate rises in 2022?
There are many factors for the MPC to consider in the short to medium term when setting UK base rates. The next meeting is in May, with a consensus that rates will rise again. As you can see from the graph below, the previous short-term peak was 0.75% in 2018, and then rates fell off a cliff, hitting 0.1% in 2020, staying there for much of 2021. At the time, there were concerns that interest rates could even move into negative territory to encourage borrowing and spending/investing and discourage saving.
Fast forward to the end of 2021, supply issues and rising commodity prices, as a consequence of pent-up demand during the coronavirus pandemic, began to take hold. As the price of gas and commodities ran rampant, it was evident that the Bank of England (BoE) would need to act to cool consumer demand. As a result, we saw the base rate increase to 0.25% in December 2021, 0.5% in February 2022 and a further rise to 0.75% in March.
Many experts had been calling for higher interest rates since mid-2021 as it became apparent inflation, even before the recent spike in energy costs, was becoming a problem. While the interest rate increases began to emerge in December 2021, there are concerns this was too little too late.
There is intense speculation that rates will rise again in May 2022 (if not before), with the cost of living crisis headline news. The MPC is acutely aware that any increase in base rates will prompt lenders to increase their finance rates, thereby squeezing household incomes further.
In addition, there are also serious concerns that unemployment could also rise from 3.8% at the moment to 5%. This would place further pressure on household incomes, lead to more significant loan, credit card and mortgage defaults and place additional downward pressure on short-term economic growth. It is safe to say this is a precarious situation!
Bank of England MPC base rate strategy
Looking at the MPC base rate strategy in more detail, it is fair to say that it has been unclear over the last 12 months (this is being kind!). Historically, investors, economists and money markets have looked to the Bank of England for direction regarding short to medium-term interest rates. Constant flip-flopping on policy over the last 12 months has undoubtedly dented the short-term reputation of the “Old Lady of Threadneedle Street”. It is easy to forget that the Bank of England has been a leader among central banks since it first opened for business on 19 July 1826.
Stuck between a rock and a hard place
Even though criticism regarding the relatively slow response to the rising inflation rate is perfectly valid, the considerable increase in energy prices due to the Russian invasion of Ukraine was out of the bank’s control. We also have the array of issues that emerged as the worldwide economy moved out of lockdown and started returning to a degree of normality after the worst of the pandemic.
There was substantial pent-up demand in many business areas, a shortage of commodities and difficulty recruiting both skilled and unskilled labour. This led to significant wage inflation, which filtered through to businesses and the cost of goods and services. If ever there was a perfect storm, this was it!
In the long term, base rates in the UK have varied significantly since 1973. In the 20 years to 1993, interest rates were in a relatively fixed band between 8% and 14%. Between 1993 and 2008, there was a step down in this band to between 4% and 7%. Then we saw the US subprime mortgage crisis, which led to a decade of historically low interest rates, and then the pandemic.
While interest rates have recently increased from 0.1% to 0.75% (a 650% increase), they are still at relative historic lows in the broader context.
While it is challenging to forecast with any absolute certainty the level of interest rates in the next 12 months, the consensus is that rates will increase significantly. Some experts suggest rates could hit 1.5% by the end of 2022, while others see potential to rise to as high as 2%. There is also speculation that rates could increase to more than 2% by early 2023. While this would assist in the battle against inflation, it would also significantly impact the already fragile UK economy.
Outlook for fixed-rate mortgages
Once it became clear that the Bank of England intended to increase base rates towards the end of 2021, this prompted a sharp repricing of mortgage rates by mortgage providers. Overnight, hundreds of fixed-rate mortgage deals disappeared as each interest rate rise was announced. The market quickly began to price in expected base rate changes throughout 2022 and early 2023. This has had a significant impact on mortgage availability for first-time buyers, existing homeowners looking to remortgage and the housing market in general.
To give you an example, below is a table showing a selection of fixed-rate and variable-rate mortgages (60% LTV) with HSBC as of 18 April 2022:-
|
Mortgage term |
Lenders Fixed-rate | Lenders Standard Variable-rate |
| Two Year Fixed Fee Saver | 2.44% | 3.79% |
| Two Year Fixed Standard | 2.14% | 3.79% |
| Three Year Fixed Fee Saver | 2.54% | 3.79% |
| Three Year Fixed Standard | 2.19% | 3.79% |
| Five Year Fixed Fee Saver | 2.54% | 3.79% |
| Five Year Fixed Standard | 2.19% | 3.79% |
| Five Year Fixed Premium Standard | 2.16% | 3.79% |
The risk premium associated with a 95% LTV mortgage saw published fixed-rates increase to between 2.79% and 2.89%. This reflects the ongoing rise in base rates and the potential for mortgage defaults, with high inflation putting pressure on household incomes and relative spending power.
To put this into perspective, homeowners who took advantage of earlier fixed-rate mortgages may be paying just 2.5%. This equates to monthly mortgage repayments of £897 on a £200,000 25 year mortgage. Once this fixed-rate term expires, if they were to move to the lender’s standard variable rate, currently 3.79%, this would see monthly mortgage payments increase to £1,033. As the Bank of England is forced to raise rates, this will increase the pressure on homeowners.
There are some challenging times ahead for mortgage brokers looking to find the best deals for their clients!
Savers continue to suffer
The cruel irony of the current situation is that savers, who had built up their funds on deposit, are also suffering. Even though some savings rates have increased in the last few weeks, they are still only a pittance compared to more traditional economic scenarios. Moreover, there are still many instant access deposit accounts offering 0% interest, although surely this must change in the short term.
The financial crisis, pandemic and ongoing conflict between Ukraine and Russia have had a monumental impact on savings accounts. Zero or minimal savings rates have meant that savers have, since 2008, seen a constant erosion in their relative spending power. As the cost of living rises, in line with inflation, those living off their savings cannot maintain a constant lifestyle. For example:
Monthly household expenditure 2021: £1000
Inflation: 7%
Comparable monthly household expenditure 2022: £1070
Funds held in savings account: £1000
Savings interest rate: 0%
For illustration purposes, with inflation at 7%, £1000 monthly expenditure in 2021 would need to rise to £1070 to maintain parity. As a consequence of 0% savings rates, those living off their savings would find themselves £70 short of retaining their relative spending power. Through no fault of their own, cautious savers have seen their funds decimated since 2008. If inflation were to hit double digits in the short to medium-term, the impact would be even more pronounced!
Does the US Fed have any influence?
Global economies are more interlinked today than they ever have been. Consequently, central banks around the globe are in constant communication and tend to work in tandem. While changes in US base rates, announced by the US Federal Reserve Bank, have no direct impact on UK base rates, everything changes in relative terms. There used to be an old saying in the stock market:
“When the US sneezes, the UK catches a cold.”
This is perhaps a perfect way to illustrate the long-term connection between central banks worldwide, with the US very much the leader. The US authorities are experiencing similar difficulties to the UK, with inflation running rampant at 7.9% (a 40-year high). So what does this all mean for the UK and base rates in the short, medium and longer-term?
Interest rate rises appear inevitable
It seems inevitable there will be yet further short-term pain, in the shape of base rate hikes, to combat out-of-control inflation. In one of the most delicate balancing acts, the Bank of England MPC will need to find a way to protect short-term economic growth while also reining in inflation. As these are at different ends of the spectrum, predicting what might happen in the coming months isn’t easy.
Even now, in the second quarter of 2022, economists are split as to how high base rates will go in the short term. Many believe they will hit 1.5% in 2022, with others suggesting they could hit 2% and move even higher in 2023. But, of course, there are many outside factors to consider, the major one at the moment being the Ukraine conflict. In hindsight, maybe, just maybe, the Bank of England was too slow to react to the threat of inflation towards the end of 2021?
In all honesty, no economic expert alive today has experienced anything anywhere similar to the current crisis. Consequently, potential short-term solutions are very thin on the ground. There is no overnight fix, and it appears interest rates will move gradually higher in the coming weeks and months.