The future of interest rates: What the experts say

Will the base rate stay put or begin its ascent? It seems no-one can agree.

It’s something of an understatement that the Monetary Policy Committee (MPC) has an exceptionally difficult task on its hands in setting interest rates right now. There's a fine line between keeping inflation under control and choking off economic recovery.

Once again the committee chose to keep rates on hold in August - that’s the 17th consecutive month of no change. Minutes from previous meetings reveal one MPC member has already voted in favour of raising rates, so the tide could at last be starting to turn within the committee. But let's not get too hasty in concluding this means a rise is reasonably imminent.

After all, there are convincing arguments for both tightening and loosening monetary policy going forward, which means there’s little consensus on what will happen to interest rates amongst the experts.

The Ernst & Young ITEM Club forecast, for example, suggests the base rate will stay put until the end of 2013. Meanwhile, in stark contrast, two senior economists Sir John Gieve former Bank of England deputy-governor, and Charles Goodhart a former member of the MPC, believe rates will have to rise earlier and more sharply than expected.

Gieve is expecting a recovery in the economy and has said rates could even climb as high as 2.5% over the coming year to keep inflation in check.

Why is there such a difference of opinion?

Of course, there are a multitude of factors at play here. Interestingly, growth has been much stronger than expected so far in 2010. The UK economy has undergone three consecutive quarters of rising GDP (gross domestic product). In fact, in the second quarter of the year, there was a surprisingly high increase of 1.1%.

This would suggest low interest rates have indeed played their part in helping to oil the economic wheels. But inflation is still far above the government’s 2% target, with the latest Consumer Prices Index (CPI) figures standing at 3.2% in the year to June.

Most analysts don’t believe the strong GDP figures are sustainable with contraction in the economy possible later this year or in 2011. Forecasts for GDP will likely fall, given the consequences of £113 billion of spending cuts announced in the coalition’s emergency budget and the hike in VAT from 17.5% to 20% which will take place in January 2011.

Other threats to the economy, such as continued weakness in the eurozone and a lack appetite for lending to businesses from the banks, could also take their toll.

The rise in VAT will fuel inflation again - which could put it even further above the 2% target - while the economy is left in a position of weaker growth. This suggests decisive action from the MPC will be required. But in the latest quarterly inflation report, the Bank of England insisted inflation will fall below the target within two years.

Everything appears to hinge on whether the MPC’s top priority will be reigning in inflation or strengthening economic growth, but this is spectacularly tricky to call in the current climate.

Those experts who anticipate a sustained recovery in the economy sooner rather than later predict the base rate will start return to normal levels in the near future. While others, who are less optimistic on prospects for growth, claim rates will stay low some time to come, like the Ernst & Young ITEM Club forecast which anticipates the effects of the June budget will slow recovery for the next two years.

What does the man in the street think?

In a recent user poll conducted by Fair Investment Company, most respondents forecast base rates rises within the next 12 months. The table below outlines the results:

Base rate predictions for the next 12 months

Source: Fair Investment Company.

As you can see, two-thirds (67%) believe interest rates will rise above 0.5% by July 2011, with a minority of 3% predicting the base rate will be higher than 2% over the same period. But again there’s very little agreement here either.

What does all this mean for you?

The consensus that rates will stay low for a prolonged period is getting shaky. If rates do start rising soon, there could be some welcome relief on the way for savers, who have suffered pathetic savings rates for many months.

Having said that, the banks have been dancing to their own tune when it comes to setting the returns paid from savings accounts. The base rate has stayed at exactly the same level since March 2009, and yet the rates on many accounts are still enduring savage cuts. A rise in the base rate won’t necessarily guarantee better rates across the board, but the best-buys should reflect the change in direction.

But there isn’t much good news for homeowners if rates rise, particularly those with variable rate mortgages who have been enjoying lower monthly repayments. After all, borrowers with trackers will feel the effects of a base rate rise on their budgets instantly. And those who have moved onto their lender’s low standard variable rate may find they need to switch if the rate starts to climb.

If you’re about to remortgage and are standing at the fixed rate versus tracker cross roads, it’s certainly worth thinking about this partial shift in opinion. And the same goes for savers who are weighing up whether to stick with variable rate accounts or take their chances on a fixed rate bond.

More: Great news! Interest rates set to stay low for years | It’s time we benefitted from massive bank profits!