Tuesday, September 22, 2009

Interest Rate Forecasts 2010 and Beyond

Readers Question: Where can I find a reliable forecast of interest rates over the next 5 years. I have seen wild claims of everything from a minus figure in 2010 to 15%. I am interested in likely mortgage rates. Is it likely that interest rates could rise by 1% a year over the next 5 years?

interest rates

Predicting interest rates is difficult. At the start of 2008, when interest rates were 5%, and inflation was above the governments inflation target, how many people would have predicted within 12 months, interest rates would have fallen to 0.5%?

Like many economic factors, interest rate forecasts are more likely to be accurate in the short term than the long term. I think most economists would be reluctant to forecast interest rates more than 1 or 2 years in advance. To predict interest rates in 5 years time, you might as well throw a couple of dice - hence the variety of interest rate forecasts you may have come across. In fact many economists are reluctant to get into forecasting because you are dealing with so many unknown and unpredictable factors.

It is quite possible interest rates will stay at 0% during 2010. Consider these factors:

  • Recession deepest for a while. Output has fallen 6%, leaving a large amount of spare capacity
  • Continued rise in unemployment will depress wages, inflation and consumer spending.
  • Banks and consumers are seeking to pay off the 'hangover' of a decade of debt. Hence, we expect saving rates to continue to rise.
  • The evidence of Japan suggests that when an asset bubble bursts, the economy can be stuck in a period of stagflation for several years. Although UK house prices have stabilised in recent months, they still look overvalued on long term price / earnings ratios. Therefore, with wealth declining consumers will be reluctant / unable to spend and this causes sluggish growth or even a double dip recession.
  • As long as growth is well below the trend rate of 2%, inflationary pressures will be absent and the Bank could keep interest rates low.
  • The government will probably have to raise taxes / cut spending. This deflationary fiscal policy will enable monetary policy to stay loose (interest rates low)
Why Do Some People Forecast a Sharp Rise in Interest rates?

You could say that the economy is due to bounce back from the recession. Furthermore, the combination of :
  • Increasing money supply through quantitative easing
  • Large fiscal deficit
  • Depreciation in Pound
All create inflationary pressure. Especially through increasing money supply, the Bank could be creating substantial inflationary pressure in the medium term. Therefore, as inflation picks up, the bank will be forced to raise interest rates to prevent this inflation.

My Opinion

At the moment, I can't see anything in the economy which suggests a return of inflationary pressures. The CPI measure of inflation continues to fall to 1.6% - below the governments target. Unemployment continues to rise and the most striking feature of the economy is one of spare capacity and more bad news to come.

This is not to say, inflation and interest rates couldn't rise sometime in 2010 and 2011. As the depth of the recession took us by surprise, the recovery could return quicker and stronger than we expect. But, at the moment, I can't see that.

The graph on this page - interest rate predictions show that in August, the mean expectation was for rates to be around 4% in 2012. But, you always have to bear in mind this is a guess as much as a prediction.

If I was a homeowner taking out a mortgage, I would want to be budgeting for a rise in interest rates to 5-6%. In the foreseeable future, I can't see interest rates rising above 5%. But, in economics the 'foreseeable future' may not be very long at all!

At the end of the day, if you really could accurately predict interest rates (unlike the rest of the market professionals), you would be able to make a lot of money on the interest rate swap market.

1 comment:

Interest in advance mortgage said...

Conversely if interest rates fall a borrower with a fixed interest rate is relatively worse off because they do not benefit from the fall in variable rates. Thanks for sharing.