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109: The UK rate rise explained

01-14-2007 team


So why did the bank of England shock the city and economist with a surprise interest rate hike on January 11th? – in answer - there was no reason not to raise rates:



The wild card is the oil price. When the oil price rises, it tends to act as a tax on the economy and slow it down although it puts pressure on inflation. When the oil price drops, its like having a tax break and fuels the economy and growth. Oil prices have dropped from $78/barrel to $52/barrel (gas from 80p/therm to 25p/therm wholesale) so this will fuel GDP growth. The above trend growth would therefore need to be kept under check by an interest rate rise. A new trend has developed - the Bank of England seem to fire the trigger early on interest rate rises if oil prices drop, but pull it slower when oil prices rise. This is because they wish to control growth and the stimulating or suppressing effect of the oil price – very wise.


Overall, rates moving to 5.25% is not likely to slow the housing market much in SE England and London, but it could take any heat out of the market in the Midlands and North of England and Wales. This is because in the north incomes tend to be lower and interest rate rises have a proportionally higher impact on consumer behaviour, particularly at the lower end of the market. have an intuitive feeling that the Bank of England are taking too much account of the booming London services businesses and house prices – and the effect of the extra interest rate rises will lead to very slow growth in the north and west, which are more exposed to manufacturing, tourism and public sector investments. It will likely lead to a more pronounced two speed economy – the south continuing to grow at rates of 3 to 4% GDP whilst the north and west languish at 1 to 2%. This is likely to be mirrored in house price increases in 2007 (refer to Special Report 106 on our predictions for 2007).


Overall, not a good day for property investors, but lets hope it’s a big warning shot – and we do not see interest rates rising to say 5.75% by year end (as they did in Australia and New Zealand in 2006). The good news is – when rates finally come down and one day merge more closely with the lower Euro rates, this will lead to lower borrowing costs and likely higher asset prices – possibly end 2008 onwards.


So – important to have a war chest to take one through this higher rate period. Also, important to be able to detect any signs of a house price crash precipitated by increased interest rates – so watch this space. No sign yet, but it could be just around the corner (unlikely) and if it is – it would represent a good buying opportunity if/when it has played itself out.


Because "neutral rates" are thought to be around 5%, with growth strong and inflation heading for 3%, there seems little reason to keep rates at 5%. Be warned - it is not impossible the bank will raise rates again in February to 5.5% to coincide with the next quarterly inflation report (we put a 30% chance to this). If you consider if inflation rises above 3%, the bank will have to explain in writing what it is doing to get inflation back below 3% - and they only have one lever - interest rates.   


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