Will interest rates rise or fall?

Definitions

Interest rates impact both spending and saving. When you save, you lend money to someone (often a bank), and the company pays you a return based on the interest rate. If you borrow money, you have to repay interest to the lender. These rates vary: for example, borrowers almost always pay more for their loans than savers receive on their savings. However, ultimately interest rates paid and charged by banks and other reputable lenders in the UK depend on the central interest rate, or bank rate, set by the Bank of England. The bank rate is the rate of interest the Bank of England charges on the loans it makes to banks and other financial intermediaries.

Since 1997, the Bank has been independent - which means that it sets the interest rate itself, as decided by a panel of experts known as the Monetary Policy Committee (MPC). Before 1997, the Chancellor of the Exchequer decided the rate and could alter it for political as well as economic reasons. Independence means that interest rates are now set solely according to the performance of and outlook for the economy.

How interest rates effect people differently

Naturally, it would be very useful to know whether interest rates are going to rise or fall in 2010 and beyond. Rising interest rates are good news for savers and bad for borrowers - particularly where large-scale loans such as variable rate mortgages are concerned. A small increase in the interest rate can mean a substantial increase in monthly mortgage payments.

Conversely, a falling interest rate is unwelcome news for savers, who will receive less return on their savings: but good news for borrowers on variable rate loans whose repayments will be reduced.

What determines interest rates?

As we’ve seen, the Bank of England sets the rate, and other financial institutions take their lead from this bank rate. So for example a bank deposit account might pay a set percentage of the bank rate; a bank loan might be charged at the bank rate plus however many more percentage points the market will bear.

The Bank of England sets interest rates to achieve its monetary policy. This in turn is designed to deliver stable prices through low inflation; and to support the government’s economic objectives, including those for growth and employment.

At the start of 2010, the inflation target is 2 per cent as measured by the Consumer Prices Index. There are no set targets for the other objectives, but typically a low but positive rate of economic growth (say, 2 to 3 per cent) is regarded as desirable, and unemployment needs to be kept low. These variables give some idea of what might influence the direction of interest rates in 2010.

What might cause interest rates to fall in 2010?

At the beginning of 2010 we are in an unusual situation: we are in a recession (in other words, the economy is contracting rather than growing); inflation is low and unemployment is high. In this situation, the Bank will keep rates as low as possible in order to stimulate economic activity by encouraging business loans and other spending. And indeed, the bank rate is at a historic low: it was reduced to 0.5 per cent in March 2009 and has remained there ever since.

What might cause interest rates to rise in 2010?

Let’s now imagine a different situation. Suppose the UK economy in 2010 were enjoying positive growth, if unemployment was low but inflation was threatening to get out of control. In this type of scenario, it would make sense for the Bank of England to increase interest rates, reducing demand for money and therefore helping to 'cool off' inflationary pressures.

Obviously, the Bank’s MPC takes many factors into account, and it’s not always possible to know which way the next decision will go. Sometimes even experts in the City are wrong-footed by the announcement. However, the general trend of the economy should give you some indicator of how things are likely to move.

Bookmark and Share
Updated on 12th January, 2010

Puzzle Corner