Interest rates – increases on the horizon

What is in store for interest rates? It is sensible to consider the Bank of England’s own comments in relation to this, which are that when they do start to raise rates it will do so only gradually and to a level materially below its historical average. This is a message we’ve been giving to clients for some time.

So what?

What is the impact of this on my pension scheme? The answer is; not a lot. Whilst the debate over when base rates will start rising makes good headlines and scintillating dinner table conversation, the reality is that the timing is fairly irrelevant from a pension scheme’s point of view.

Whilst February 2015 is as good a guess as any for the first rate hike, the key point for pension schemes is that when rates begin rising they will do so slowly and will peak at a lower level. It is the latter considerations; speed and ultimate level that will have the biggest impact on your scheme.

Background

When, and by how much, are interest rates going to increase? Starting with the market, a 0.25% hike is currently being priced in for the first quarter of 2015. Following this, rates are expected to rise gently to reach approximately 2.25% in three years’ time.

Turning to the Monetary Policy Committee (MPC), the minutes of the August meeting showed that two of its nine members broke ranks (for the first time in three years) and voted for an increase in the UK base rate to 0.75%.
Rate hawks shouldn’t start celebrating just yet; there are still a number of factors weighing on the conscience of Mark Carney, current Governor of the Bank of England, and the other committee members before go ahead is given for the hike.

Firstly, there’s the development that twelve month CPI inflation actually fell to 1.6% in July compared to 1.9% in June. These figures were not known at the August MPC meeting. Admittedly there are certain one-off effects at work here, such as the delaying of summer sales; however with inflation now below the MPC’s inflation target of 2% since November 2013 this provides further justification for those wishing to delay a rate rise.

There are a number of key factors that the MPC look at when reaching a view on future inflation and therefore base rates; these include the outlook for growth and the labour market, the strength of sterling, and the level of spare capacity in the economy.

Over recent quarters the UK economy has continued to experience strong growth in both output and employment, with the unemployment rate now standing at 6.4%. However, a somewhat less rosy picture is painted when wages and productivity are considered. Wage growth continues to lag inflation and the fall in productivity experienced following the financial crisis was larger than in any other post-war recession. The larger the spare capacity in the economy the longer the MPC can potentially delay a rate rise. Unfortunately, spare capacity is notoriously impossible to predict and the MPC has admitted that there’s a variety of views around the committee. Their central view remains that there is still some slack in the economy.