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Don’t Believe The Rumours – The Low Interest Rate Era Isn’t Over Yet

Charlotte Haye 17th January 2016 ROC News

Over the last few months there have been some encouraging rumours that the low interest period in the UK economy might finally be drawing to a close. And while we might all want this to be true, sadly, it’s anything but. In fact, it’s safe to say that Britain’s rock bottom interest rates are going to stay exactly where they are. This is mainly because all of the signs point towards very low inflation for the foreseeable future, which in turn removes any motivation the central banks might have to raise their base interest rates. This in turn will set the benchmark for mortgages, overdrafts and loans for years to come.

How Does Inflation Affect Interest Rates?

Put simply, inflation is the gradual rise in price of goods and services over time. It is usually measured as an annual percentage, much the same as interest rates, and the two figures are intrinsically linked. Inflation is one of the key indicators for the health of the economy. If inflation is rising, your economy is robust and growing nicely, and in an ideal world you will see wages rising at the same rate. If inflation has reached a standstill, or worse is getting lower (or ‘deflation’) this is a very bad economic indicator. One of the major drivers for inflation is interest rates, and it’s movement can push the economy in certain directions, as you can see through this graph.

Screen Shot 2015-11-27 at 10.10.44

There are 2 theories that explain the relationship between inflation and the health of the economy. One is the cost-push theory, and this explains that when the cost of raw materials and input increases, so does the cost of the end product, resulting in higher retail prices. The second theory is the demand-pull theory. This theory suggests that lower interest rates will attract lower saving rates, with people wanting to spend more when they aren’t getting the most from their savings. This creates more demand for goods and services, and the inclination to spend results in more borrowing from banks. All of this increased spending results in higher prices for goods and services, which in turn results in inflation. In a healthy economy, inflation and interest rates move hand in hand, and are mutually dependant on each other.

Predictions For The UK Market

Interest rates and inflation have been at rock bottom rates for over 6 years, and there are no signs that this will change. In fact, some central banks are now looking to pour funds directly into the economy just to keep inflation from sinking into the negatives. The annual figures are published in June, and at the moment the UK’s market inflation is currently expected to be 0, a long way off the hopeful 2% target. The Monetary Policy Committee may attempt to placate this by stating their expectation of inflation rises in the next few years, and the impact of creating nearly 2m jobs has had on the economy. And while high rates of employment can’t be ignored, it has not created the wage pressures that were expected. What they won’t mention is how the real average earnings of UK households have only just recovered to the level they were in August 2004, and that we now live in a climate where most families are so strapped for cash, they need to take out a loan just to buy a sofa or a car.

The other factor affecting inflation rates is the state of global trade, which has begun falling again after it’s strong recovery. Global trade is now always dependant on the Chinese authorities flooding the market with cheap goods, but following the Beijing crash it has been suffering. A recent effort to kick-start the economy saw China devalue the yuan, with a reduction of around 3% against the dollar. While this might not be the most decisive of moves it will still have some effect on the west, mainly in more lower inflation rates. With authorities, banks and governments all rushing to pay back debts they built up before the economic crash, it seems unlikely that any movement will be made on this issue in the near future.

Charlotte Haye 17th January 2016 ROC News

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