3 February 2022

How high will interest rates go?

Last time inflation was this high, interest rates were at 10 per cent. Could that happen again?

Illustration by Aron Vellekoop León / Ikon Images

When the cost of living starts to rise, the Bank of England deploys its secret weapon: raising interest rates. Raise rates, and people are inclined to save more and borrow less – which reduces spending, which reduces demand, which slows price rises. This is why, faced with inflation at a 30-year high, today (3 February) the Bank decided to increase rates by a quarter of a percentage point, to 0.5 per cent.

A quarter of a percentage point hardly seems earth-shattering, considering inflation is at 5.4 per cent and rising at a rate that has bypassed most economists’ expectations in recent months. Last time inflation was this high, in 1992, the interest rate was almost 10 per cent as the Bank of England tried to wrestle it back down. Is there a chance that could happen again?

Janet Mui is the head of market analysis at Brewin Dolphin, an investment manager. She says today’s announcement was most likely the beginning of an incremental chain of rate rises, or a “hiking cycle”. Markets have predicted four or five rises this year, as energy prices continue to push up the cost of everything else. “I think four seems fair,” she says.

Central banks tend to adopt a slow-and-steady approach to rate hikes in an effort to avoid shocks to financial markets, so it is unlikely the Bank of England would raise it any more than 0.25 percentage points each time, Mui says. That means the Bank’s base rate probably won’t rise to more than 1.25 per cent this year.

Martin Weale, an economics professor at King’s College London who served on the Bank of England’s rate-setting monetary policy committee (MPC) between 2010 and 2016, is inclined to agree. He says financial markets’ consensus suggests interest rates will peak around 1.5 per cent, although he adds that the Bank of England may be inclined to go further.

“I’m not saying that 1970s-style inflation is coming,” he says. But he cites a study by the Office for Budget Responsibility (OBR) looking at “what would happen if inflation expectations become entrenched”. The study suggested rates might climb as high as 3.5 per cent. “I suppose I see there’s a bit of a possibility, I would have said in November,” he says, although he adds that his real expectation is “somewhere between” the market’s prediction of 1.5 per cent and the OBR’s expectation of 3.5 per cent.

What could cause that entrenched inflation? “A lot of that depends on where energy prices are going,” says Mui – and because energy prices will be in part determined by what happens in Ukraine, that makes it hard to predict. “It is very hard to look beyond this year,” she says.

A series of rate rises will come as yet another poke in the eye to one particular group: first-time house buyers. Figures released on Tuesday by Nationwide showed house price growth was at 11.2 per cent in January, the strongest start to a year since 2005. If rates start to rise, people buying their first home this year – who have struggled to save because of low interest rates and who are now being forced to stump up higher deposits than ever – will now have to pay more to borrow, too.

The good news, says Mui, is that house price growth may begin to slow, albeit modestly. “I’m not saying that there will be a correction in the housing market. That’s absolutely not going to be the case.” She points out that the market’s fundamentals continue to be strong, meaning that demand for property is outstripping supply. She expects, “at most, flattish house prices or a bit of slowdown in that growth rate,” she says.

The other benefit is that even the top-end prediction of 3.5 per cent is well below anything experienced in previous decades. Weale says that’s a consequence of high levels of saving, predominantly by the baby boomer generation – but it could begin to reverse. “Once people born before 1970 have mostly retired, then you might think that this high level of savings will be reversed. Interest rates may start to go up again,” he says. For borrowers, that’s bad news – but for those putting money away for their first home, that extra help can’t come soon enough.