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When will UK interest rates rise?

UPDATED: 20:25 GMT, 17 May 2013

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A lowering of inflation expectations has eased the pressure further on the Bank of England's monetary policy committee to raise interest rates.

Presenting his last quarterly inflation report as Bank Governor, Sir Mervyn King said the rate - which currently stands at 2.8 per cent - is likely to edge higher in the coming months, but will come down more quickly than was expected three months ago.

At the same time the Bank said growth should pick up to 0.5 per cent in the second quarter of this year but warned that the hangover from the financial crisis would ensure the recovery is weak and uneven - adding to its case for keeping rates low.

No green shoots: The gloomy outlook for the economy could see the Bank of England keep rates on hold for the long haul

In its May meeting the MPC kept base rate at 0.5 per cent and its economy-boosting asset purchases on hold. That came as positive industry data raised optimism on the country's recovery from recession.

Industrial production rose by 0.7 per cent in March, according to the Office for National Statistics, providing new confirmation that the economy has returned to growth. The figure was well above forecasts for a 0.2 per cent rise, and made negligible the chances of the Bank's monetary policy committee voting for an increase to quantitative easing.

The ECB has finally joined the 0.5 per cent interest rates club, cutting its benchmark rate from 0.75 per cent to combat the ongoing eurozone struggles.

Back on this side of the channel, economic data has looked better with a manufacturing, services and construction pick-up following news of the UK dodging a triple-dip recession. The economy grew by 0.3 per cent between January and March this year.

Whether these are the start of green shoots or not, the base rate is expected to remain at a rock bottom 0.5 per cent for the foreseeable future.

Swap rates have ticked up slightly of late but the money markets are still pricing in a 0.75 per cent bank rate in summer 2017 at the earliest. A rise to 1 per cent is not anticipated until autumn 2018 and we're not expected to see 1.25 per cent before late 1919.

This is despite inflation showing no signs of hitting the Bank of England’s notional 2 per cent target for some time.

The rate of inflation remained stuck at 2.8 per cent in March - its highest level since May last year - according to Consumer Price Index (CPI) data released by the ONS last week.

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It is forecast to rise even higher this year, stoking fears of a summer of financial pain for consumers. CPI is predicted to peak at 3.5 per cent, pushed higher by food prices and recent gas and electricity increases. Water bills are also due to go up next month.

 

But Osborne and the Bank of England's rate-setting monetary policy committee have made it clear that trying to kickstart growth is the main item on the menu and above-target inflation will be tolerated for some time.

On Thursday May 16, five-year swap rates stood at 1.05 per cent - up from 0.91 per cent at the start of this month.

But that is still down on the 1.2 per cent seen in February.

Budget measures to add more flexibility on rates

In the Budget, Chancellor George Osborne announced new measures to give Mark Carney, who is set to become governor the Bank of England from July, more control.

The measures include increased flexibility to use ‘unconventional’ measures to support the recovery - but Carney will still have to meet a 2 per cent inflation target.

Earlier this year, a top Bank official commented that negative interest rates might be an option to kickstart the economy - a suggestion which prompted a flurry of activity in the swap markets that forecast future rate trends.

Deputy governor for financial stability Paul Tucker disclosed to MPs that a dramatic move to negative interest rates was debated at a monetary policy committee meeting.

His fellow deputy governor Charlie Bean immediately downplayed the idea, saying there was nothing to prevent a negative rate in principle but it was 'blue sky thinking'.

'I personally don't like this route,' added Bean. 'It is one that creates all sorts of issues.'

Big freeze: Interest rates have been on ice since the financial crisis

Cutting the 0.5 per cent rate further to below zero would effectively mean depositors, such as high street lenders, would have to pay the central bank to hold their money.

The hope would be that banks would therefore choose to lend out more of their funds rather than stockpile them, and help fuel a recovery.

Although swap markets immediately factored in the prospect of negative interest rates, this was a prime example of how they are useful in reflecting forecasting trends but can sometimes diverge from reality.

Almost no one thinks that negative rates are a serious possibility except in the most extreme and dire economic circumstances. Think scenarios such as Italy crashing out of the eurozone and sparking an overnight chaotic collapse of the single currency.

To get it into perspective, swap markets have for some time now predicted a cut to 0.25 per cent within the next few years, but this is still considered most unlikely to happen even though the MPC rate-setters dutifully discuss it every month.

Economic experts say that for practical reasons it could curb lending rather than increase it, making it counterproductive as a method of promoting recovery.

HOW DO YOU FORECAST FUTURE INTEREST RATE RISES?

We can't - no one can. But we look at overnight swap rates to work out roughly when money markets forecast the Bank Rate will start to rise from the rock-bottom level of 0.5 per cent. 

This is very far from a precise business - not only do financial traders make wrong predictions all the time, but swap rates are only a snapshot of their views at a given moment in time.

The recent knife-edge forecasts of a triple-dip recession - odds-on one week, off again the next - demonstrate how quickly the outlook for the economy and inflation can shift, and will constantly alter opinion on where interest rates will go.

Money market forecasts often diverge from reality, as well. For instance, swap markets have for some time now predicted a cut to 0.25 per cent within the next few years, well before a hike to 0.75 per cent is likely to materialise.

However, this is considered most unlikely to happen even though the Bank rate-setters dutifully discuss it every month. Economic experts say that for practical reasons it could curb lending rather than increase it, making it counterproductive as a method of promoting recovery.

The overnight swap rates can also be read in different ways. Take a look at the following chart, which appeared in the most recent Bank of England inflation report and illustrates interest rate projections in May compared with February.

Outlook: The Bank of England's May Quarterly Inflation report mapped out the market's expected path for Bank Rate.

But a recent chart released by the Office for Budget Responsibility analyses the data differently and projects rate hikes will happen sooner.

Source: Office for Budget Responsibility report

Economists also make predictions of when rates will go up, which are often quite different from those signalled by the money markets.

We frequently quote their views here too if they help shed light on the issue for readers.

You can then consider all the available information and make your own best guess on when interest rates will rise.

Why 'swap rate' money markets matter to savers and borrowers

When markets move a decent amount - and the move holds - it can affect the pricing of some mortgages and savings accounts. When swaps price a rate rise to come sooner, fixed rate savings bonds tend to marginally improve in the weeks that follow. But it also puts pressure on lenders to withdraw the best fixed mortgages.

As for using swaps as a forecast, we've consistently warned on this round-up that they are extremely volatile and should be treated with caution - they should be used more as a guide of swinging sentiment rather than an actual prediction.

Important note: Markets, economists and other experts haven't had a great record of making the right calls in recent years: 2010 predictions 2008 predictions. This is Money has always advocated caution with any sort of prediction (including our own!). There's no guarantee that those who have made correct calls in the past will make them in the future. [More: Whether to trust predictions]. We'd also urge consumers not to gamble with their personal finances when it comes to predicting rate swings.

Rate rise predictions: Money markets and economists

Swap markets reflect the City's bank rate expectations - not in an exact way, but they indicate trends in forecasting.

Some swap rate prices and and charts are displayed below to show how the market moves as economic prospects shift.

22 May 2012 (after inflation figures ) • 1.31% - one year • 1.28% - two years • 1.49% - five years

25 July (after dire GDP figures)• 0.91% - one year • 0.80% - two years • 1.03% - five years

8 August • 0.82% - one year • 0.80% - two years • 1.07% - five years

2 October• 0.75% - one year • 0.71% - two years • 1.00% - five years

21 November• 0.67% - one year • 0.70% - two years • 1.06% - five years

12 December• 0.65% - one year • 0.66% - two years • 1.00% - five years

16 January 2013• 0.67% - one year• 0.72% - two years• 1.12% - five years

19 February• 0.64% - one year• 0.69% - two years• 1.19% - five years

6 March (after Bank of England raised possibility of negative interest rates)• 0.57% - one year• 0.59% - two years• 1.05% - five years

19 March

• 0.57% - one year• 0.61% - two years• 0.97% - five years

28 March (after big chill and Cyprus crisis heightened triple-dip threat)

• 0.60% - one year• 0.61% - two years• 0.95% - five years

16 April (after inflation sticks at 2.8 per cent)

• 0.58% - one year• 0.58% - two years• 0.93% - five years

25 April (after UK narrowly avoids triple-dip recession)

• 0.57% - one year• 0.58% - two years• 0.92% - five years

16 May (after Sir Mervyn King upgrades growth forecast)

• 0.59% - one year• 0.62% - two years• 1.05% - five years

One-year swap rates (which influence one-year fixed-rate bonds)

Since January 2011

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Five-year swaps (influences 5-yr savings bonds and fixed mortgages) Since January 2010

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Beware false dawns

In early 2010, markets prematurely began pricing in a greater chance of rate rises because of rising UK inflation. They did the same again in early 2011. But as we've repeatedly argued on this round-up, deflation rather than inflation has remained the greater long-term threat. Treat claims of rapidly rising rates with caution!

What decides rates?

The BoE's Monetary Policy Committee meets once a month and sets the bank rate. Its government-set task is to keep inflation below 2% (and above 1%), looking two years ahead. So if inflation looks likely to pick up, it raises rates.

Viewpoint: Why rates WILL rise 

The 'inflation nutters' (in the words of former BoE MPC member Adam Posen) fear that measures aimed at reviving the economy - rate cuts and masses of quantitative easing - have unleashed forces that will create rampant price rises and that rate rises will be needed to prevent hyperinflation taking hold. They also fear rising demand from emerging market economies will push up prices.

When inflation was worryingly high in 2011, these views gained traction.

One popular theory is that Western governments want to create inflation to try and erode their record debts, created in part by bailing out banks. Billionaire Warren Buffett (right) warned about this in August 2009 well ahead of the pack (as usual).

One controversial economist warned inflation would force the MPC into a series of rate rises, taking the bank rate to 8% by 2012.

Weak sterling in 2010 and 2011 also added inflationary pressure: falls in the pound make it more expensive for Britons to buy foreign goods, effectively importing inflation. [ what next for the pound?] And we're also importing inflation from booming China.

Others point out that rapid rate rises are rarely expected. Insurance service RateGuard points out periods of quick-fire increases in the chart below.

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