With interest rates in the UK likely to continue rising over the near future, Joshua Raymond, the Director at online investment platform XTB, has shared his expert thoughts by answering some of the most topical questions surrounding interest rates in the UK today:
With such high interest rates being brought in to bring down inflation, why is inflation still at such high levels in the UK?
Inflation in the UK has proved much more stubborn than in other G7 countries and in many ways, the Bank of England has been seen to have been too slow to act aggressively at the outset. UK inflation peaked at 11.1% in October 2022 but has been slow to cool in recent months especially. Inflation remained flat month on month in May at 8.7% whilst surprisingly core inflation – which strips out volatile elements such as energy and food – rose to 7.1%.
Much of what the Bank of England is trying to do is reduce demand side aspects contributing to inflation. By hiking rates and raising the cost of borrowing, you reduce purchasing power. Yet it must be said that UK inflation is also being heated by supply issues.
Take a look at the UK labour market for example, which still remains lower than pre-Covid levels. Moreover, there’s been a 4.5% increase in working activity since Brexit, which has forced employers to ‘raise their game’ in an effort to retain staff. This has increased business costs which are being passed onto consumers and keep inflation high. For example, recent private wage growth data showed a rise of more than 7.7%, a record outside of the Covid era.
Taking one sector as an example, manufacturing firms have increased employee pay by 7.8%, which is the highest growth rate since record began in 2001. This has significant impacts on margins if the same firms don’t pass the cost increase onto customers, and as long as there is demand, they have no motivation not to cut prices.
Inflation is expected to decline in the coming months, especially thanks to the cut in the energy price cap from 1st July. Yet the concern is that inflation won’t cool as fast as needed and as a consequence, the Bank of England will keep pushing rates to as high as 6.5% by the start of 2024, and rates will likely maintain at high levels through 2024 despite the likely damaging impact on the economy.
Are we more likely to see interest rates go up or down in the near future and why?
We now expect UK interest rates to continue to rise to around 6.5% by the start of 2024. Having lagged behind the inflation curve for much of the year, the Bank of England’s MPC needs to front run expectations now, which means it has to be aggressive on rates to effectively shock demand side influences contributing to inflation. It is essentially sacrificing economic growth in the near term to bring inflation back down to target to help support consistent growth in the medium term.
This means bad news for mortgage holders, those on fixed terms about to expire and those on variable rates. We’ve already seen the average 2yr fixed rate trade at around 6.6%, whilst the average 5yr fixed rate has also now surpassed 6%. There is every expectation now that those rates will continue to push higher before the end of the year.
Just as importantly, however, and it’s not being spoken about much yet, is the likelihood that rates stay high for much longer than previously anticipated. Whilst rates are expected to peak by the end of the year, given how stubborn UK inflation is proving and the supply strains, its likely rates will have to stay high for longer to keep inflation lower. That means mortgage rates will likely enter a new normal in 2024 where more borrowers will be forced to transition from previous fixed term rates of around 1-2% to 5-6%.
How does the current interest rate in the UK affect other sectors such as housing or business?
The main goal of increasing interest rates right now is to cool demand side aspects from heating inflation. Higher rates raise the cost of borrowing and incentives consumers to keep more cash at the bank to earn higher interest yields. So, the sectors which will be affected the most from higher interest rates are those reliant on debt.
For example, homebuilders, tech firms will likely see their cost of operations rise substantially, hurting margins. Equally banks typically benefit from higher rates as consumers keep more cash at the bank and banks are typically slow to pass on higher interest rates to their customers. In general terms, higher interest rates for longer raises the likelihood of the UK slipping into a recession in 2024, which is not good for most sectors meaning this could also raise the attractiveness of defensive sectors such as defence and pharmaceuticals.
How should investors attempt to navigate these periods of high interest rates?
One market that has become extremely popular of late is the British pound sterling, which has seen huge interest from XTB clients. The pound has strengthened against the US Dollar by more than 20% since September 2022 (height of the budget crisis) and recently hit a new 14-month high thanks to market expectations that the BoE will need to raise UK rates much more aggressively.
The pound has also gained around 20% against the Japanese Yen since December 2022 and recently hit its highest levels since 2015. With these types of gains and expectations of more interest rates to come, it’s easy to see why trading the GBP is so popular right now.
Simply the worry I have is consumers are currently underplaying the impact of high rates for an extended period of time and mortgage holders especially need to consider their options. It may simply not be the case that switching temporarily to variable rates or to a 1yr/2yr fixed won’t be as efficient as it seemed at the start of the year.