With the swish of his pen, Bank of England governor Mark Carney can make your mortgage cheaper or more expensive. He can change how much it costs the UK government to borrow money too. And the interest rate on savings accounts usually follows suit as well.
It’s an extraordinary power if you think how much money the government borrows. Brits spend a huge portion of their monthly income on the mortgage – the rule of thumb is a third. And many people feel forced to invest their savings into risky assets thanks to a lack of interest on their savings accounts.
So what does the future hold for interest rates?
Predicting interest rates was my planned career path at university. That was back in 2007 when I wanted to be a bond trader. After the financial crisis, which nobody predicted, routed the job market for bond traders, I went to work for the industry that did predict the financial crisis. And here I am trying to do the very same thing for you – figure out what the Bank of England’s interest rate policies have in store for you.
The best way to predict the future is to understand the past. But before we get to that, what’s the state of things now? The Bank of England’s Monetary Policy Committee kept rates at 0.25% at its last meeting. Only one member wanted to increase rates, despite the fact that inflation is already above the 2% target.
For now, economists predict the Monetary Policy Committee will keep rates where they are until 2018. But the fear of inflation is growing as the warnings over Brexit fail to materialise.
Where could interest rates go?
There are bigger picture questions at hand if you want to predict interest rates. We’ve never had such low interest rates, especially for so long. Surely the only way they can go is up?
What about the enormous mountain of debt we’ve accumulated while rates were so low? If interest rates do go up now, could we afford all that borrowing?
To answer those questions, first let’s set the scene. Because central bankers are tasked with running the economy by influencing the interest rate, their primary influence is debt. The interest rate is the price of debt and the reward for lending. If you move it around, you influence people’s saving and borrowing patterns.
Of course central bankers want an economy that’s doing well. But this makes them keep interest rates too low and encourage more borrowing than is really healthy. Eventually inflation breaks out and interest rates have to go up to reign it in. Then borrowers who stretched themselves too far are in trouble.
We’re in the last phase of this cycle
Inflation is rising, but there is so much debt that the central bank risks a crisis if it raises interest rates. For example, One River Asset Management chief investment officer Eric Peters modelled the consequences of interest rate increases in the US. He concluded that they could not rise above 3.5% without enormous defaults and unemployment.
In the UK, we are world record holders when it comes to borrowing. We could afford even less of an increase.
Here’s the fascinating thing. The fact that higher interest rates would have disastrous consequences is so well understood that many are betting their financial lives on it. They’re borrowing like mad in the belief that rates won’t be allowed to go up. They might be right. But that leaves inflation unchecked.
What central bankers predict
Central bankers are hoping that the economy picks up enough to paper over the debts. If people earn more, they can afford higher interest rates.
The problem is that debt is borrowing from the future. You sacrifice your future income for the sake of a windfall in the present. Because of this, debt only makes sense if you invest your money in a way that helps you generate more income in the future. It has to be a bigger increase in income than the cost of the debt, which is the interest rate. So if a business buys a machine that doubles its profitability to 15%, but the loan to fund the machine only cost 7% interest, then it’s a good idea.
But we have been using our debt to buy property and consumer goods. Mortgage and consumer debt doesn’t generate future economic growth. They don’t enhance productivity.
The economic gains we’ve had from increased debt are largely an illusion. They are a sacrifice of future economic activity. Instead of reaping the benefits of our efforts in the future, we will have to send those rewards to the creditors.
The strange world central banking has created
All this debt has created a surreal world. We now use credit to purchase just about everything in our lives. People are now willing to borrow vast amounts. When the banks refuse to lend, parents step in to lend their children money to buy a home. More than a quarter of home purchases are now bought with family money, making the Bank of Mum and Dad the ninth biggest mortgage lender in the UK.
When house prices increase, people feel richer. This is a little odd when you stop to think about it. Shelter is a necessity. If you try to sell your house to realise your gains, the house you have to buy for a new home has gone up in price too. On the whole, we don’t benefit.
In a world where it’s too dangerous to increase interest rates but inflation is already rising, Carney and the Monetary Policy Committee face an impossible task. They will have to choose the lesser of two evils – inflation or the defaults that interest rate increases will cause.
Category: Central Banks