What higher interest rates mean for you

James Norton from finance experts Vanguard explains the reason for higher interest rates and why inflation has been more persistent
than expected. He also explores what it might mean for your investments and for mortgage rates.

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The Bank of England (BOE) raised interest rates by 0.5 percentage points to 5% on 22nd June, leaving the base rate at its highest level since 2008. And further rises may be on the cards. Our economists now think the base rate will probably peak at either 5.5% or 5.75%, up from our previous forecast of 4.75% or 5%.

This comes after data showed higher-than-expected inflation in the UK, coupled with a tighter-than-expected jobs market. The annual rate of change in prices for goods and services stayed unchanged at 8.7% in May, just when economists had been expecting a further fall. That compares with the Bank of England’s 2% inflation target.

So-called ‘core’ inflation rose to 7.1%, from 6.2% in April. Core inflation is used to measure the underlying rate of inflation. In the UK, it excludes energy, food, alcohol and tobacco, as these measures are seen as more volatile or are heavily taxed.

Why is inflation stronger than expected?

Coming into 2022, we saw a surge in energy and food prices due to Russia’s invasion of Ukraine, which compounded the increased inflation we saw coming out of the Covid pandemic.

Surprisingly, the shock in energy prices has proven to be larger in the UK than in the eurozone. European governments capped prices sooner than the UK, and our prices have been slower to fall back, due to technical reasons around how the price cap was implemented.

But it is core inflation, which strips out the energy effect, that is the bigger concern as it is closely tracked by the Bank of England when setting interest rates. And UK core inflation is now higher than in the US and euro area.

Among the reasons for this is the fact that labour shortages remain a problem for the UK, with the inactivity rate, the proportion of working-age people not in the workforce, some 1.5 percentage points higher in July 2022 than in February 2020.

A tight labour market with shortages of workers puts employees in a stronger position when negotiating wage rises to cope with higher prices. This can further fuel inflation as companies pass on higher wages through higher prices, driving an inflationary spiral.

It is not clear that there is this ‘wage-price’ spiral in the UK yet, though services inflation, i.e., the price of something like a haircut, rather than a physical object, has picked up. Services inflation tends to be the most persistent, which is why many commentators are calling inflation ‘sticky’. Fundamentally, the Bank of England wants to see weakness in the UK labour market such as through a decline in job vacancies.

How have markets reacted?

Financial markets have responded by anticipating higher interest rates from the Bank of England, which has fed through to higher government bond yields and mortgage rates.

Rate rises will feed into the mortgage rate that banks can offer. On 22nd June, according to Moneyfacts, the average rate for a two-year fixed mortgage was 6.19% while the average five-year fix stood at 5.82%, having averaged 3.25% and 3.37% a year ago, respectively. And they could have further to rise.

The Bank of England is now raising rates more aggressively again, with June’s rise of 0.5 percentage points coming after three quarter-point increases earlier this year.

Higher interest rates are the textbook way of dealing with inflation. By raising the cost of debt like mortgages, you suck demand out of the economy. As consumers cut back on their spending, companies realise that they cannot pass on an increase in prices, and inflation moderates.

The challenge is that this can take time. How long it takes for rate rises to affect the economy is difficult to say, but it may be around 12-18 months. In fact, according to the Bank of England, we are yet to see most of the impact from the increase in interest rates that started in December 2021.

The impact of higher rates is also unlikely to have as big an effect as in the past. More than half of homeowners own their property outright now. Mortgage costs are just not a factor for them. It all suggests that interest rates may have to stay higher for longer with the Bank of England unlikely to cut rates until mid-2024 at the earliest.

What does it mean for my investments?

For those who have investments, there are several things to bear in mind. When central banks are raising interest rates, it can mean there is less fuel for growth, which can weigh on shares. Markets may start to worry that central banks will raise interest rates too much and choke the economy rather than moderate it.

Longer term, however, if higher rates make economic growth more sustainable, it can be good news for shares.

And what about bond markets? (For an introduction on what bonds are, read this article). Higher interest rates often lead investors to demand a higher interest rate or yield on the bond. The only way for this to happen is for the price of the bond to fall. Bond pricing is affected by other factors too though.

But longer-term, bond investors should ultimately benefit from higher rates because your money will be reinvested in higher-paying bonds that can generate better total returns. We would expect the UK government bond market to stabilise as a result of the Bank of England’s actions to tackle inflation.

Ultimately, the current uncertainty in the UK provides a reminder of why it is so important to have a globally diversified portfolio across both shares and bonds. This means that any short-term volatility in UK shares and bonds may be offset by the performance of shares and bonds in other markets.

Markets may be more volatile in the short term, but our research shows that investors who ignore short-term market noise do better in the long run. It’s time in the market, not timing the market, that ultimately delivers investment success.

*James Norton is Head of financial planners at Vanguard, Europe.

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