Base Rate at 5.5% is not the last word
By Chris Gilchrist    17th May 2007

The Bank of England raised Base Rate by 0.25% to 5.5% on Thursday last, and though many economists think this is the high point, I expect at least another quarter-point rise in the next few months.
The Bank has to believe that the rise in interest rates will nudge inflation down towards its 2% target. Interest rate rises typically take 18 months to affect the price level, but this year we’ll see inflation drop anyway as domestic energy prices fall.

Energy price cuts are expected to knock at least 0.4% off the inflation rate by the end of the summer. The issue is whether 'core’ inflation will also fall, and here opinion is more mixed.

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Core inflation could prove tougher to reduce I’m with the pessimists, who think that rising prices of goods and services are now feeding into private sector wage claims. I also doubt whether the latest rise will have much impact on the housing market or on consumer spending.

A rise in interest rates transfers money from young to old and poor to rich, because the young and poor have mortgages and debts and pay more interest, while the old and rich have money in savings accounts and get more interest.

But the old and rich spend less of every extra pound of income they get than the young and poor do, so rising rates do tend to damp down consumer spending. But my betting is that the effect won’t be very noticeable.

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Mortgage costs are a bearable pain
After the latest quarter-point rise, the monthly cost of a £150,000 repayment mortgage will increase by £23 per month, while the same-size interest-only mortgage will cost an extra £31 per month.

But while people in the South-East will suffer, the average FTB mortgage is only £114,000 (an extra £17 per month) and the stats show that the average FTB is spending 18.3% of their income on mortgage payments, which is still well below the level that applied at the last housing market peak in 1989.

Moreover, in recent months over 75% of borrowers have been taking fixed-rate mortgages, and overall it’s estimated that about 50% of all existing mortgages are on fixed rates. That’s a lot of borrowers who won’t face any increase in their repayments -bad news for the Bank of England, which hopes that interest rates rises will restrict consumers’ spending, which will in turn slow down the pace of price rises as competition gets fiercer on the High Street.

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Not the end for property
The rate rise probably won’t do much to stop the property market either. In many areas, you can still save money by buying rather than renting and so long as that’s the case, people will keep on buying.

The top end of the London market is an exception that nobody can make any sense of. People are paying £1 million for houses they could rent for £30,000 a year, and this could only make sense if the value of the house kept on growing - but that would require the rent to rise dramatically, and nobody has come up with any reason to expect rent increases big enough to justify that kind of rise in value.

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Expect another quarter
So I’m expecting another quarter-point rise in Base Rate by summer. And unlike some of the City optimists, I reckon interest rates will stay at that level until well into 2008.

Though fixed mortgage rates will rise a bit in the next few weeks, you will still be able to get a fixed rate at about 5.3-5.4% and it still makes sense to take the fixed rate option rather than risk more pain with a variable rate.

Article produced by EveryInvestor.co.uk