In the aftermath of last week’s increase in the UK base rate the Bank of England has come under intense scrutiny. There are concerns that the interest rate cycle upturn has come too quickly for the UK economy which is still struggling. There are also worries that those who made full use of cheap finance when base rates were at historic lows may be overstretched as interest rates slowly tick higher. So, was the Bank of England right to increase the UK base rate?
Inflation
Inflation will become an issue in the UK in the short to medium term. Even though the rate has fallen a little since hitting 3% in September, a full one percentage point above the Bank of England’s target, it is a worry. Currency movements over the last 12 months have made imports significantly more expensive and one report this week suggested that inflation would increase by one percentage point in the event of a “no deal” on Brexit. It is fairly easy to calculate the expected increase in various commodities and services if the UK is forced to revert to World Trade Organisation (WTO) tariffs. So, an increase in the UK base rate does seem to be justified when looking at inflation.
The economy
While any economic forecasts for the UK in the short to medium term are mere speculation, until we know the terms of the Brexit arrangement, the Bank of England is not exactly upbeat. Expected GDP growth of 1.9% in 2017 is looking more like 1.7% and recent forecasts of 1.7% growth in GDP during 2018 have since been downgraded to 1.6%. The third quarter of 2017 showed disappointing GDP growth of just 0.3% and sluggish growth is expected for the final quarter. It may be that the UK economy is struggling because of the uncertainty surrounding Brexit, the UK government may well agree a deal beneficial to all parties but at this moment in time a “no deal” is certainly on the table. So, if we are looking at the economy in isolation it is difficult to justify an increase in the UK base rate.
House prices
House prices have held up surprisingly well in light of the Brexit vote back in 2016 although there could be trouble ahead. A chronic long-term shortage of housing stock in the UK is to a certain extent supporting the prices we see today. The same can be said of historically cheap finance prior to the 0.25% increase in the UK base rate last week. Therefore, while this does not reflect the whole of the UK, there are certain areas of the country where these two elements have created a “false market”. The subtle increase in UK base rates, with the full 0.25% likely to be passed on to variable rate mortgage holders, could trigger something of a short-term sell off.
There is the opportunity to use the current economic climate and growing personal debt to check the growth in UK house prices and perhaps make them more affordable to first-time buyers. On the downside, wage inflation is running at less than cost of living inflation so in reality the spending power of the UK consumer is being eroded.
Conclusion
Cheap finance fuelling the economy, potential “false” property markets in some areas of the country and the need to rein in inflation are perhaps justifiable reasons to increase the UK base rate. There will be pain, so-called “zombie” companies could fall by the wayside but this short-term pain should hopefully clear the decks and lead to some long-term gains.