Are Higher Interest Rates your Friend or Foe?
The Bank of England’s intentions to raise interest rates has helped to lift Sterling back higher every time it’s knocked down by Brexit uncertainty. It’s good news for people who transfer Sterling abroad because it increases their purchasing power, raising their living standards. The Pound’s weakness has been the cause of the UK’s 3% inflation rate, according to the latest Office for National Statistics’ Consumer Price Index.
The Bank of England (BoE) is poised to increase interest rates in the coming months to limit inflation and strengthen the economy. This raises the question: What will higher interest rates mean for you?
Wall Street reacts to the end of “cheap borrowing”
The US stock market suffered its worst week in over two years, just last week, due to concerns about interest rates rising faster than had been expected. The recent global market gyrations that have wiped off trillions in fiscal value from stock markets stem from fears of inflation leading to rising interest rates.
The dramatic fall suggests the markets are nervous about higher interest rates, which tends to make most of us feel apprehensive, as well. The markets are adjusting after low interest rates helped investors to borrow and invest cheaply in assets like property and shares that have risen steadily. Businesses and investors worry that higher bank loan rates will trim their profit margins.
For a decade, quantitative easing has driven down interest rates so investors could borrow cheaply, but, now that the global economies are booming, it’s time to slowly withdraw the unprecedented stimulus programme. Raising interest rates is part of the plan to wean the UK off of Quantitative Easing (QE). If unwinding QE weakens the economy, the BoE can then cut interest rates to smooth the transition.
With the expectation of higher interest rates, short-term US government bonds are worth far less; there’s more incentive to purchase an investment that matures more slowly. There’s an inverse relationship between bond prices and interest rates because when interest rates rise, investors prefer the higher yield that comes with bonds that mature more slowly.
Inflation worries have caused US 10-year Treasury yields to push to a four-year high. These treasuries that mature in a decade are used as a benchmark that guide the Federal Reserve (Fed) in their decision to raise interest rates, increasing the odds that the Fed will raise interest rates.
BoE “in no rush”
Bank of England’s chief economist Andrew Haldane said this week that the central bank is keeping “a very strong eye on inflationary developments,” which are ahead of the bank’s 2% target rate. He said the BoE “was in no rush” to raise interest rates, nor would they go back to levels seen in the past. Emphasising the BoE’s intentions to keep the cost of living under control, Haldane said that some further tightening of policy is seen as the “single best and most important thing we can do to help the economy generally and, within that, in particular to help those households who are feeling the pinch financially.”
The jury is out on how the increase in interest rates will help the average UK household, in the long-term. The immediate impact won’t be pleasant, given that household debt totals nearly £1.9trillion. Low income households will tumble deeper into debt, after having just managed to survive financially over the past decade on cheap credit. The Resolution Foundation has said that 45% of low-income families are already in debt distress. One in six households report being in arrears on their mortgage or consumer debts and over a third are struggling to pay for accommodation.
Inequality in debt
A study by the foundation found that younger households (headed by someone 25 to 34 years old) spent nearly £1 in every £5 of their pre-tax income on debt repayments last year, compared to only 20 pence spent by households headed by people aged 65 and older.
The Financial Conduct Authority said that those in financial distress were more likely to be people with children who were younger, unemployed and less educated than others who were not economically over stretched. The FCA also noted it was concerned about rent-to-own loans and car loans as risks to potentially vulnerable customers.
The extra cost of inflation at its current rate of 3% means that UK households must find an additional £864 a year, to maintain their standard of living compared to a year ago, according to Retirement Advantage. The organisation tallied that to a total of £23.5billion a year, which makes it clear why consumer spending in January had its first decline in five years, according to an index by Visa.
Higher interest rates will impact wealthier homeowners with large mortgages, as Britons can expect to pay almost a third more on their mortgages and other household debt in the next five years. According to a Labour party analysis of data from the Office for Budget Responsibility, the average household will see an increase of £468 in annual debt costs, due to higher interest rates. This year, average annual household debt costs are around £1,983, and expected to rise to £2,451 by 2023.
Benefits of Higher Interest Rates
The fact that consumer credit levels have risen to over £200 billion for the first time since 2008 has been seen as a case for higher interest rates, according to Gertjan Vlieghe, a member of the BoE’s Monetary Policy Committee. “By their actions, households are telling us that at current interest rates, at least, they no longer want to ease debt burdens,” Vlieghe said.
While higher interest rates increase the cost of borrowing, they are also a boon to workers who will depend on invested retirement funds for their income. With higher interest rates, retirement funds rely on bonds that mature more slowly to increase investment income, which deliver higher returns to those who will retire with a higher fixed income.
Higher interest rates are good news for savers and investors who would have turned to stocks to get an inflation-beating return. Another upside is a stronger Pound which drives inflation down because it decreases the cost of imported goods. Stronger Sterling also means that buying property abroad is less expensive, since you get a better exchange rate when you transfer your Pounds overseas to pay for your property.
The bottom line is that higher interest rates make it essential for households to stop borrowing to stay afloat. Since higher interest rates drive down inflation, hopefully the lower cost of living can help them do this.
For those who are more financially stable, an increase in interest rates is a good time to re-access your investments. Consider the changes in the markets as an excellent reminder to review your financial plans whenever your own circumstances or the larger economic conditions change to make sure that you keep your financial goals up to date.
If one of your goals is to invest in property in the UK or abroad, now is the time to investigate a low fixed-rate mortgage. If you are planning to invest in an overseas property, register with Currency Solutions to increase your buying power. Inflation and interest rates are significant financial factors that are easier to forecast than exchange rates. The good news is that, while none of us has control over inflation or interest rates, you can lock in exchange rates by using specialist financial tools like forward contracts. You’ll find that registering with us is free, fast and easy and puts you in the driving seat when it comes to moving your money.