As expected, the Bank of England (BoE) again kept its base rate at 5.25% last week, the fifth consecutive freeze at a 16-year high. Although inflation pressures now show clear signs of easing, the Bank is set to keep a tight grip a while longer as it gains more confidence that price rises above the 2% target are truly vanquished.
More notable was the shift in the balance of voting on the Bank’s Monetary Policy Committee (MPC) which revealed a greater consensus of views. At February’s month’s meeting, the nine policymakers were split three ways. Six voted to hold interest rates, two wanted a rise, and one a cut. This time around the two members voting for a rise removing their calls, meaning all are now looking for unchanged or lower rates.
What are interest rates and why have they risen?
Interest rates represent the cost of borrowing or the reward for lending or saving. If you’re a borrower, the interest rate is the amount you are charged for borrowing money, shown as a percentage of the total amount of the loan. The higher the percentage, the more you have to pay back for a loan of a given size.
- For instance, say you borrow £1,000 from a bank. If this loan has an annual interest rate of 10%, you will have to pay back £1,000 plus 10% interest (£100). So £1,100 is the amount you would owe after one year.
- If you are a lender, or you’re a saver (a bank will typically loan out money it holds on deposit) the interest rate represents the return you receive. The higher the lending or savings rate, the more will be paid to you based on the amount loaned or, in the case of savings, the amount in your account.
The interest rates set by institutions depend on lots of things, notably who they are lending to, how risky they are, and how long for. However, they are also driven by the rate of interest set by the Bank of England (BoE) – so called ‘base rate’ – to control inflation. If prices are rising too quickly the bank can raise interest rates to make borrowing more expensive and cool demand, which can help rein them in. Conversely, if price aren’t rising and the economy is in slump, the bank can help stimulate demand by cutting interest rates to make borrowing cheaper.
When will interest rates go down?
In the absence of inflationary curveballs, it’s now a matter of when, not if, interest rates will be cut. Price pressures are showing clear signs of easing and will recede further still with energy costs poised to fall by 12% as the Ofgem price cap is cut in April.
A base rate of 5.25% would be at odds with price rises coming much closer to target as the year progresses. The Bank’s own forecasts now show inflation will not just fall to target but dip below it by the second quarter of this year owing to the freeze in fuel duty announced in the Budget.
At the same time, the BoE is cautious of declaring victory too early and letting inflation back out of the bag. The Bank is no doubt pleased with the recent drop in CPI inflation to 3.4%, but services inflation, indicative of domestic inflationary pressures, is still running too high at 6.1%. It is likely to want to squeeze this out of the system before risking a significant cut to rates.
Escalating wages and a general tightness in the labour market could continue to exert upward pressure on the overall inflation rate. With tentative positive signs coming from the economy and consumer confidence reaching a two-year high, the Bank will be wary of inflationary embers being rekindled later in the year, especially with a rise to the minimum wage coming in April alongside a further cut to National Insurance that stands to add to household spending power.
Overall, it seems likely the balance of MPC members will lean towards keeping rates where they are for a couple more months as they await concrete evidence that wage growth and services inflation are falling back, which will more conclusively signal that price rises can sustainably return to target. However, that approach does come with the risk of curtailing the economy’s tentative progress out of shallow recession, as well as maintaining the pressure on households with significant borrowings.
Read more: Financial priorities during a cost-of-living squeeze
Are high interest rates good for savers?
The prospect of continued falls in inflation along with higher interest rates is good news for savers. For a period at least, it could mean the opportunity to increase the spending power of cash.
- For example, with inflation at 3%, the new spending power of £100 by the end of the year is £97. But if you received an interest on that money of 5%, the inflation-adjusted or ‘real’ value of the money would rise to £102.
- It’s a case of making hay while the sun shines though. Interest rates are likely to trend lower with markets currently anticipating three 0.25% cuts by the end of the year. That would take BoE base rate down to 4.5%.
Meanwhile, inflation is expected to dip but then trend gently upwards again in the second half of the year, meaning interest rates and inflation are set to converge. But in the short term there is the prospect of a period of significantly inflation-beating returns from cash, at least if a competitive rate is secured, as the best rates available from banks and buildings societies tend to quickly reflect the BoE rate.
After a decline at the start of the year, fixed savings rates have now stabilised but are expected to gradually fall back as BoE base rate cuts approach. Therefore, if you are looking for a fix it might make sense to act sooner rather than later, though bear in mind this will mean locking your money away without access for the stated period. Meanwhile, the best variable rates are expected to continue to edge lower too as the year progresses.
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