This week the inflation rate in the UK went to 2.5%. This is extremely relevant in the mortgage world as there tends to be a direct relationship between inflation, the Bank of England base rate, and therefore the best mortgage rates on offer. So this is a good time to look at that classic relationship, and also to look at why it is different this time and the outcomes may not be as expected:
Why is the inflation rate linked to Interest Rates?
In simple terms, it is all about disposable income and spending.
The dynamic tends to work in that if the inflation rate is low or falling, central banks tend to lower interest rates to free up cash from personal and corporate purses, so it can be spent on goods and services. This increases demand and tends to push up prices.
Conversely, if the inflation rate is high and/or rising, central banks often raise interest rates, decreasing spare money that hampers spending on goods and services, which then brings down costs.
So far, so simple. As any interest rate movements take time to move through the financial system, central banks have to be hyper-vigilant to get future decisions correct. Specifically, in the mortgage world, most people only renew their mortgage once every 2 or 5 years, and only a small portion of mortgages are on variable rates (only 4.7% in 2020 according to Statista).
As mortgage, or rent, is normally the single largest outgoing for most households, the Bank of England needs to consider – is any spike in inflation likely to be long term to warrant a higher cost in 2 – 5 years when people come to renew their mortgages? As those who live by the Crystal Ball are destined to eat broken glass, that is a really tough job at the best of times.
Why does the Bank of England Target interest rates at 2%?
It is also worth considering why the UK, and nearly all central banks, target inflation around the 2% mark. In very simple terms again, it is to keep people spending.
As most western economies are consumer-based, it is in their interest to keep buying things when needed or ahead of time. As if what you want to buy today will be more expensive tomorrow, you buy now.
We are seeing that very clearly in the housing market right now as prices are on the up, it is a huge incentive for people to act now rather than delay. This is why we have also seen several depressed years in the housing market as in 2016 there was the referendum result, which leads to uncertainly and at least stagnation of prices with some areas (like London) seeing prices go down, so people held off buying.
Then Covid came along which made the future even more uncertain. Now we have finalised Brexit (even if no one actually understands what that is), and the Government has put billions into ensuring banks keep lending, you are now seeing the knock-on impact of house prices going up due to pent-up demand and easier credit conditions. The smart thing to do would have been to buy a new house before 2019, but herd mentality normally scuppers that even if it is in your interest to do so…
Why is it different now?
If we go back to that classic dynamic, you could well put off people spending if you do raise interest rates. After Covid, there isn’t any gain to be had to put off people from spending money now.
In fact, that could well stifle any bounce back we may see in the second half of the year. As it is still quite uncertain what lockdown ending/easing means, it could be many months before we really know where we stand with the virus and the long-term impacts on the economy.
Also, inflation figures are hard to gauge as year-on-year comparisons can’t really be relied upon as we spent much of 2020 in lockdown.
Lastly, we are now only really feeling the impacts of Brexit. Higher costs for goods and services are inevitable, so it may just be a case of us having to adjust to higher prices, as opposed to traditional inflation (in that it may just keep going up). the view from the Bank of England presently is that this rise in inflation is very transitory, but they are keeping a watchful eye on it.
What can you expect in the future for the inflation rate and mortgage rates?
That really is the million-dollar question. As touched on above, and as illustrated by the graphs below, normally when inflation goes up, rates go up.
That is a direct correlation in years gone by, but we are in anything but normal times. In the longer term, it is beneficial to have interest rates higher than they are today. If you are a saver or rely on investment income, a low-interest-rate environment is not good at all. In fact with interest rates being at ultra-low levels, it is a disincentive to save, and an incentive to borrow. With both personal households and the UK in more debt than has ever been the case in the past, this endless cycle of borrowing just can’t continue. It makes finances too unstable and debt servicing stars to eat up valuable money that could (and arguably should) be spent investing for the future.
So we do need to dig our way out of this hole and it is going to take time. The long-term average for the UK Base rate is 5%, but we are unlikely to see the base rate go above 3% in our lifetimes unless anything dramatic happens.
So what we should see is a gradual climb out of this ultra-low interest rate environment in the coming years. We would not be surprised to see the ‘emergency’ cut from the Bank of England be reversed in the next 6-12 months (which would put rates back to 0.25% from 0.1% currently), but it will then have to be a suck-it-and-see response.
While 0.15% is only a small move, it is still doubling the Bank of England’s benchmark rate. You wouldn’t go from 5% to 10% easily, and hence why it is so hard to get out of this cycle. But done carefully, as GDP rises, and inflation stays broadly in check, it is very much in the public interest to get interest rates back to something resembling ‘normal’ in the coming years. We would not be surprised to see the base rate stay below 1% for at least the next 5 years, but if the long term trajectory is upwards, even modestly, it does seem sensible to lock into the current batch of low fixed-rate mortgages to safeguard you against any potential rises in the future.
Please do pick up with one of our advisors and we will happily talk over what this means for you, and your specific circumstances.