The Effect of the Recent Rise in Interest Rates on the UK Economy
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The Bank of England recently announced a rise in interest rates of just 0.25%
but hinted that interest rates may rise as high as 6%. These rates are low
compared with the early 1990s when within the ERM interest rates reached a peak
of 15%. However despite the relatively low levels of interest rates. There are
important factors to consider. Firstly the real interest rate is very high. The
real interest rate is the actual interest rate – inflation. With core inflation
remaining low around 2% the real interest rate is becoming quite high. This is
good news for savers but bad news for the UK borrowers. Secondly the UK is
experiencing record levels of debt, especially amongst consumers. This is partly
because of increasing willingness to borrow but also because of rising house
prices. This means to get on the property ladder consumers are increasingly
having to get increasingly large mortgages.
Many home owners are borrowing much more than the historical levels. The old
formula of a mortgage 3 times your salary is being replaced by mortgage deals
that can be 5 or 6 times your salary. The effect of this is that consumers are
increasingly indebted and mortgage payments take a higher % of people’s income.
Therefore this means that consumers will be increasingly effected by rising
The first and most obvious impact of rising interest rates is that it will
reduce consumers willing to borrow and spend. Interest payments are more
expensive, and increased mortgage payments reduce disposable income. Also saving
money becomes more attractive. However the impact of rising interest rates on
consumer spending is always uncertain. There are often time lags in reducing
spending patterns. A lot depends on how consumer confidence is effected. If
consumers start to feel interest rates will continue to rise and the economic
cycle may start to swing into a downturn their spending could fall
significantly. This will lead to a fall in spending, or at least a fall in the
growth of spending and could lead to a downturn.
It is also worth considering the effects of rising interest rates on the
manufacturing sector. Rising interest rates are likely to further increase the
value of the £ which according to many commentators is already overvalued by
historical standards. Therefore with a stronger £ exporters are likely to face
decreased profit margins and this could lead to a fall in exports. With a
decreased manufacturing sector, rising value of the £ has less effects than it
perhaps did previously. Nevertheless rising interest rates will do nothing to
lift the long standing gloom over the manufacturing sector.
However on the other hand economists point to the need for rising interest
rates. The economy remains relatively buoyant and a small rise in interest rates
now will help to bring borrowing under control. If borrowing is allowed to
increase now. Their may be a more painful readjustment in the future.
The one group of society who are the real gainers from this current situation
is savers. They are enjoying one of the highest real rates of interest for a
long time. And judging by the sentiments of the MPC at the last monthly meeting
their profitable saving return may continue for a while.
About the Author
R.Pettinger is an Economics teacher at Oxford and writes frequently on the UK
economy and mortgages. He edits a site about Mortgages including a guide to
different types of mortgages.
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Article Published/Sorted/Amended on Scopulus 2007-03-25 20:25:08 in Economic Articles