By Dr Jing Du
Assistant Professor in Finance, Birmingham Business School
We should not panic and know that in the war to combat inflation, the UK is not alone.
At the end of September, the Bank of England (BoE) announced an increase in interest rates, the seventh consecutive rise since December 2021.
The increase of 0.5 percentage points changes to base interest rate from 1.75% to 2.25%, taking the UK’s interest rate to its highest point since the global financial crisis of 2008. The BoE has also said it “will not hesitate” to hike interest rates further to curb inflation, with any necessary actions taking place in November. The market is predicating that the base rate will increase above 4% by the end of this year, and further to above 5% in the middle of 2023.
It is the Bank’s responsibility to ensure that inflation is low and stable. Increasing interest rates is its way to bring inflation back down to its target of 2%. However, higher interest rates do not work immediately and it may take a while to see any results from the change. The most recent inflation rate in the UK is 9.9%, down from 10.1% in July, which was the highest level during the last 40 years. This is the first time in 11 months that the inflation rate has eased. However, the largest downward contribution comes from the government’s announcement on energy bills, not the increased interest rate. According to the Bank of England, the inflation rate will peak at 11% in October and remain above 10% for a few months.
With the rising interest rates, fears of a further weakening of British economic growth have become more apparent. The Office for National Statistics revealed that, although the economy grew by 0.2% in the second quarter of this year, the overall size of the UK economy is still 0.2% below its pre-pandemic level.
According to the ING forecast, the economic growth in the UK would slow to 0.5% in the fourth quarter of this year and enter negative growth of -0.6% in the first quarter of 2023. The BoE projects the GDP growth rate to contract to -2.1% in the third quarter of 2023 and grow slightly to 0.4% in 2025. Back to July, the International Monetary Fund predicted a 15% probability of recessions in the G7 economies and has warned that the UK will become the country with the slowest economic growth among the G7 economies next year. A survey by Ipsos shows that almost 64% of Britons are concerned about rising interest rates, which lead to high investment cost of companies and increasing cost of imported products from fuel to food.
Higher interest rates have a direct impact on the housing market. The UK’s housing market has been remarkably resilient in the past, surviving Brexit, the pandemic, and the ongoing cost of living crisis. However, there are signs that the property market faces challenges. Although property valuation has been affected by limited supply and strong demand, house prices dropped 0.1% in summer, stopping 12 consecutive months of growth. Capital Economics predicted UK house prices will drop 5% over the next two years and warned the fall could be 15%. This trend could be good news for investors and home buyers.
On the other hand, rising interest rates would impact homeowners and new homebuyers negatively. According to English Housing Survey, 30% of households have a mortgage. With an increase in interest rates, around 2 million people on tracker and variable rate mortgage deals will experience an immediate increase in their monthly payments. Monthly repayments by households in the UK are set to rise more than £160 compared to last December. As for fixed deals, monthly payments may not change immediately, but they will also have to pay more when they look to remortgage. An average two-year fixed deal is 4.24%, compared to last November when it was 2.29%, leading to hundreds of pounds more in monthly repayment. For first-time buyers, they are now facing an average monthly mortgage payment that is 20 percent higher than at the beginning of last year. According to data from Rightmove, the average monthly mortgage payment for first-time homebuyers is currently £976, compared with just £813 in early January.
Apart from the mortgage rate, higher interest rates also have impact on credit card users and savings. Before the interest rate hike, the effective interest rate of credit cards in the UK was 18.5% in July. It is expected that the average annual interest rate of credit cards will increase, which means that credit card users will be affected negatively and pay more overdraft interests. In theory, an increase in base rate should lead to higher interest rates on savings accounts as well. However, banks act quite slow to reflect the last seven base rate rises and pass on the full amount to savers. By the end of September, Moneyfacts said that none of the high street banks had passed on all rises to easy access accounts since December last year. In addition to the effect of high inflation rate, consumers would find their money losing value in real terms.
The hike in interest rates is a double-edged sword. On the one hand, it has a certain control effect on the current high inflation rate and house prices in the UK. On the other hand, it aggravates the risk of a weakening British economy. Both individuals and organisations are exposed to heavier debt burdens, leading to a further increase in the cost of living. However, the battle is global, with The European Central Bank, Switzerland Central Bank, and the US Federal Reserve all increasing base rates by 0.75 percentage points in September. We should not panic and know that in the war to combat inflation, the UK is not alone.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of the University of Birmingham.