PropertyInvesting.net: Property Investment Special Reports

109: The UK rate rise explained

PropertInvesting.net team

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

• GDP is running at 2.7% - above trend
• Inflation is running at 2.7% - well above the 2.0% target
• House price inflation is 8 to 10% - above trend
• The global economy remains strong
• There was far less discounting in the shops over Christmas this year – retailers are using the strength of the economy to keep prices and margins high as retail sales remain robust
• Although oil and gas wholesale prices have reduced – this has still not fed through into inflation numbers
• Wage demands are above the target levels of about 3%
• Wage rounds in the next months will be critical to keeping inflation under check – so increasing in January gives a pre-emptive message to keep wage rises low
• There are signs Chinese and India export prices have leveled off which shows some early signs adding to inflationary pressures
• The Bank of England have sight of new data and forecasts on inflation that suggests inflation may be approaching the 3.1% that would mean they would have to write an embarrassing letter explaining themselves to the Chancellor – never a  nice outcome for a professional Banker
• There was no reason to wait another month
• The stock market is doing fairly well and city bonuses could fuel inflation
• Manufacturing strength both in UK and Europe is surprisingly strong
• Employment is increasing and unemployment remains low
• Broad money supply is on the increase
• Mortgage lending is rising and equity release shows no sign of declining significantly

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. PropertyInvesting.net 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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