What does the interest rate rise mean for the UK economy, house prices and savings?

The Bank of England has raised the base rate to 1 per cent to address high inflation.

The Bank of England’s Monetary Policy Committee has today (5 May) raised interest rates from 0.75 per cent to 1 per cent, the highest rate since February 2009. While interest rates remain relatively low, this will have knock-on effects on house prices, savings and the wider economy.

Why has the Bank of England raised interest rates?

The rise comes in response to data showing that inflation for the 12 months to March 2022 rose by seven per cent, as measured by the Consumer Price Index. Interest rates are used by the Bank to stimulate the economy (reducing them makes debt cheaper, encouraging spending by businesses and people) or to stop it from overheating (raising them makes debt more expensive, reducing demand and preventing further price rises).

The Bank has been raising interest rate incrementally since December, when the Bank’s governor Andrew Bailey wrote to the Chancellor, Rishi Sunak, that he expected inflation to peak at around 6 per cent in April. At the time, many economists believed that inflation would be “transitory”, but the ongoing high cost of energy suggests it is likely to be a more long-term issue, and Bank expects inflation to peak at around 10 per cent.

What’s driving inflation?

The current period of inflation is not unique to the UK. Around the world, the pandemic has caused three things to happen: massive injections of new money by central banks, changes in consumer behaviour and disruption to manufacturing and supply chains. This means there’s a lot of money sloshing around, but also shortages of products and labour, from second-hand cars to gas to HGV drivers, causing prices to spike.

The other major factor is Russia’s invasion of Ukraine, which has caused another sharp rise in the cost of energy, driving up the prices of oil and gas as Russia’s exports are restricted. The war has also caused a significant rise in the price of fertiliser (of which Russia and Ukraine are two of the world’s largest exporters), shipping (due to fuel prices and the cost of accessing some ports) and other commodities, such as palladium, that are used in global supply chains. In every case this adds to the cost of food, fuel and other goods in the UK.

What is stagflation?

Stagflation refers to a period in which the economy is stagnant or in recession, but prices rise anyway. Inflation isn’t in itself bad; the rising prices and rising wages of last year were though by many economists (and the Prime Minister) to be symptoms of an economy that was bouncing back, and the Bank’s job was to ensure it did so in a controlled way, without “overheating”. In a period of stagflation, monetary policy can become less effective, because lowering interest rates will push prices still higher, but they won’t be followed by real incomes. There is now growing concern that Russia’s war in Ukraine, coupled with the economic scarring of the Covid pandemic, could push the UK and other countries into a period of stagflation.

Will a rise in interest rates cause house prices to crash?

The higher bank rate will feed into rates for new mortgages, making it more expensive to buy a house and limiting demand. It’ll also be more expensive to remortgage, which might encourage some homeowners to downsize. Most mortgages (around three-quarters), and almost all new mortgages, are fixed-rate deals, however, which means only homeowners with “tracker” mortgages, which rise or fall with the base rate, will receive higher bills immediately.

First-time buyers are the most exposed to a rate rise, caught between rising mortgage interest and rising rents, which are also a a 13-year high, making renting more expensive (as a proportion of income) than owning.

The Bank can try to get more firt-time buyers into the market by relaxing the affordability requirements on mortgages, so people can sign up to spend an even higher proportion of their income on housing, but it can’t control the affordability calculations lenders themselves choose to impose. As banks and building societies tighten these requirements, it’s likely buyers will find it harder to join the market or remortgage to buy a new property.

Will savers feel the benefit?

It depends on the kind of savings. New savings accounts will offer higher rates, but again, not much higher, and certainly not above the current high level of inflation. As a very general rule, rising interest rates also tend to reduce stock market returns (because it becomes more expensive for listed companies to borrow and invest) and cause bond prices to fall. This could mean that other investments, such as stocks and shares ISAs or pension funds, don’t increase in value as they would have done.

Older savers could be better off: those who buy an annuity with their pension will receive higher monthly payments, as annuity rates are determined by interest rates and the yields from government bonds (which rise when interest rates go up).

Should I cut up my credit card, burn it and dissolve the ashes in a caustic substance?

Yes! Not because the Monetary Policy Committee has raised the base rate, but because banks have raised interest rates on credit-card borrowing to well over 21 per cent. The rise in the base rate will only give credit card providers more reason to increase these rates, which are already at a 23-year high.

Pre-existing fixed-rate loans, like fixed-rate mortgages, are of less concern, although rates offered on new loans should also be expected to rise.