The change from one year to the next is often a time when people think about what the future will bring. One of the key questions for this year is the question of what direction interest rates will take. The answer to this question will depend on two main factors. These are government policy and inflation. Here is a quick guide to what you need to know.
Technically, interest rates are set by the Bank of England rather than the government. In reality, however, the Bank of England follows the inflation target set by the government. This is currently 2% with a +/-1% permitted margin of error. If this changes, then the Bank of England’s approach will have to change.
Even if the government does not officially change its target, it may still instruct the BofE to treat it as a guideline rather than a rule. In other words, the government may stick to its policy of wanting inflation to be at 2%. It may simply accept that this is not a practical option at a given point in time.
Assuming the government sticks to its target and the Bank of England follows it, the direction of interest rates will be determined by inflation. If inflation goes up, interest rates will follow to try to combat it. Likewise, if inflation goes down, interest rates will reduce to try to stimulate the economy. The BofE might also resort to quantitative easing.
With that in mind, here are the key factors that could influence the direction of inflation and, hence, interest rates.
Public health issues
At present, COVID19 seems to have been significantly neutralised. Unfortunately, it has not, yet, been confined to the history books. Even more, unfortunately, it is definitely not the only condition with the potential to become a serious public health issue.
Respiratory conditions in general are a growing concern. There is also concern about other highly contagious conditions such as pox viruses. The 2022 outbreak of mpox/monkeypox was on a fairly small scale. More widespread outbreaks could have very serious implications.
Any disruption to the UK’s economy could impact people’s willingness and ability to spend. This could feed through to lower inflation and hence lower interest rates.
The job market
In the context of the direction of inflation, there are two factors to consider. Firstly, there is the percentage of adults in employment. Secondly, there is their actual earning power and how this translates into spending power.
If wages keep pace with inflation, then the Bank of England may consider itself as having free rein to increase interest rates. On the other hand, if they don’t, the BofE may be very hesitant to raise interest rates. They may be concerned about increasing the pressure on people who are already stretched.
The housing market
If the housing market stays lukewarm to cool, it may act as a strong brake on inflation. When people buy houses, they often need, or want, to make other purchases as well. For example, they will need to pay conveyancing fees. They will usually have to pay a surveyor’s fee.
They will often want to customise their new home to their own needs and wants. For example, they may need to buy new furniture. Even if they have furniture from a previous home, this may not be suitable for their new one. Fewer home sales mean fewer corollary purchases. This could do a lot to cool inflation.
The energy situation
When winter ends, the UK will have less need for heating. This is likely to be a significant relief for many people. It should also help to reduce inflation, at least in the short term.
The state of food production
If agricultural production goes well, food prices should be relatively low. By contrast, if there are production issues, food prices could end up contributing significantly to inflation.
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