What the future holds for interest rates

Will the Monetary Policy Committee raise interest rates this year and what could that mean for you? Jane Baker investigates.

Last week, the Bank of England's Monetary Policy Committee (MPC) voted to keep interest rates on hold yet again. This marked the tenth month in a row where the base rate remained unchanged at 0.50%. Now we all know it will rise eventually - but the $64,000 question is when?

Surprisingly, some economists are already predicting rates could rise as early as March. Here's why:

Inflation

The ultimate aim of the MPC is to meet the government's inflation target of 2% using the consumer prices index (CPI) measure. The CPI currently stands at 1.9%. But inflation is expected to rise in 2010, owing to higher oil prices and the increase in VAT back to 17.5%, which took place on 1 January.

The GDP figures for the final quarter of 2009 (which are due to be released at the end of January) are expected to confirm a strengthening in the economy - albeit to a modest degree - and rising inflation. Indeed, recent data from the manufacturing and services sectors was better than expected, suggesting improvements in economic growth.

As an economy recovers, you'd normally expect inflation to increse. So some experts predict that the super-low base rate will have to rise soon, to keep inflation under control. Others are less convinced.

So will 2010 spell the end of an unprecedented era of low interest rates? Before we get onto that, we need to consider another important factor in the debate: the Bank of England's programme of quantitative easing. Depending on its as yet unknown success, quantitative easing could have a huge impact on interest rates this year.

What is quantitative easing and why was it necessary?

In March 2009, the base rate was cut to its all-time low of 0.5%, in order to encourage spending in the economy and boost inflation. Yet despite this record reduction in interest rates, the economy was so weak that the Bank of England was still worried that prices might start to fall, which could have been very damaging to economic growth. Realistically, the base rate couldn't be cut any further, so the Bank had to resort to quantitative easing, a highly unusual measure also known as 'printing money'.

In simple terms, quantitative easing  is the creation of fresh money which can then be pumped into the economy. All other things being equal, the more money there is an economy, the higher the rate of inflation.

The Bank of England uses the cash to buy assets - mainly government bonds (also known as gilts) - back from financial institutions. This provides a valuable injection which enables banks to increase lending to borrowers and helps businesses through the recession. This extra money supports more spending in the economy, which in turn should help to push inflation up towards the Goverment's target of 2%.

When will quantitative easing end?

The programme of quantitative easing has already been extended several times. The current programme is due to end in February, by which time the Bank of England will have purchased assets worth £200 billion. To date the Bank has spent £193 billion, leaving another leaving another £7 billion available before completion. Right now there are no plans to extend quantitative easing again, but this could change.

Will this be a turning point?

It's difficult to assess how successful quantitative easing  has been as an economic stimulus at this stage, particularly as it has never been tried and tested before. It will also take some time for the impact to filter through.

However, some analysts argue that the Bank of England has already gone too far with quantitative easing and that inflation will take off later this year as a result. So a rise in the base rate may be necessary to stop prices rising too fast.

But I can't see it happening imminently. Right now, the signs of economic growth are tentative at best and the UK is still the only major economy which remains officially in recession. Increasing rates at this critical point could be detrimental to a recovery, since credit conditions would tighten for consumers and businesses, choking off economic growth.

Despite rising prices, I suspect that the MPC will sit tight and wait for more economic and inflation data to come through over the next few months before taking any drastic action. Having said that, I wouldn't totally rule out a rate rise or two before 2010 is out.

But what does all this mean for you?

Rising interest rates will be good news or bad news for you, depending on whether you're a saver or a borrower. Here's how to prepare, whatever your situation:

Savers

I don't expect rate rises to take place in the first half of the year. This means savers may have to put up with low savings rates for some time yet. Even if rate rises do take place in the second half, the increases are likely to be minimal and probably won't have a dramatic impact on cash returns this year.

If you agree rate rises may occur later in the year, you may decide now is not a great time to open a fixed rate bond. That's because the return you get on a bond could get left behind if interest rates start to climb. Instead you might prefer to keep your options open by opting for a market-leading easy access savings account. If you can cope with only four penalty-free withdrawals a year, the best-buy is the Coventry Building Society 1st Class Postal Account which pays 3.30%. Those requiring more flexibility and access, you could for the AA Internet Extra Account which pays 3.15% - or 3.30% on balances over £50K.

Borrowers

Many lenders seem to be dancing to their own tune at the moment. For example, the base rate has seemingly no effect on the rates charged by loan and credit card providers, and this is likely to continue to be the case.

Mortgage rates, on the other hand, are more sensitive to base rate changes. But remember this is not the only factor to affect mortgage pricing. Fixed-rate mortgages, for example, are heavily influenced by swap rates which are a major factor in the cost of funding this type of home loan.   

Although some fixed and tracker mortgage rates look exceptionally low, mortgage pricing is pretty costly right now compared with lenders' own borrowing costs, as rebuilding balance sheets remains a top priority. In general, I would expect average mortgage rates - particularly on longer-term fixes which are already higher now than a year ago - to rise this year even if the base rate doesn't.

At lovemoney.com, we think longer-term fixes (over 5 years) are a good choice into today's market. If the time has come for you to take out a new mortgage or remortgage, check out The top mortgages for 2010 where we round-up the best fixed-rate deals of the moment. But remember, I don't expect rates to say this low for long. If you're a fan of trackers or discounted rates instead, there are some best-buys in there for you too.

If you have your own opinion on interest rates this year, why not comment in the box below? Or ask other lovemoney.com readers for their views using our Q&A tool.

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