This year saw the 10th anniversary of when the Bank of England took control of operational responsibilities for setting and controlling interest rates.
Since 6 May 1997, the Bank has focused on delivering the objectives it was set at the time by the government.
The past decade has been a period of remarkable economic stability in the UK. Interest rates and inflation have both been lower and fluctuated within a much narrower range since the Bank’s Monetary Policy Committee (MPC) took over responsibility for setting interest rates than in the previous 10 years.
The UK economy has grown continuously throughout the decade. It has now seen 60 consecutive quarters of economic growth stretching back to 1992 – the longest unbroken period on record.
Facts and figures
Interest rates have moved on 36 occasions since the MPC first met in June 1997; 10 times fewer than in the previous decade. Official interest rates have varied between a high of 7.50 per cent and a low of 3.50 per cent since June 1997.
During the decade before the formation of the MPC, Base Rates reached a high of 15 per cent during 1989/1990 – twice the peak in the past 10 years – and fell to a low of 5.25 per cent in 1994.
Inflation has also been lower and less volatile in the past 10 years compared with the previous decade.
The annual rate of headline Retail Price Index (RPI) inflation has averaged 2.7 per cent over the 10 years of Bank of England independence. This is nearly two percentage points below the 4.5 per cent average during the 10 years before the MPC was formed.
While the annual rate of RPI inflation reached its highest in the last 10 years in March, at 4.8 per cent, it was less than half the 10.9 per cent peak recorded in the previous decade.
There have been four lengthy periods of unchanged rates since June 1997. The longest was 15 months between November 2001 and February 2003 when rates were maintained at 4 per cent. The other three long periods of stable rates each lasted 12 months between February 2000 and February 2001, August 2004 and August 2005, and August 2005 and August 2006.
The UK economy’s stability over the past decade was the dream of both the public and policy makers during the turbulent 1970s and 1980s. During these two decades, the economy plunged from boom to bust, inflation and interest rates were often in double figures and unemployment peaked at over three million.
The MPC has played a key role in delivering the achievement of the dream of economic stability. But can this last?
The future of interest rates
The recent pick-up in inflation caused the governor of the Bank of England to write an open letter to the Chancellor last month; action that is required when the current inflation rate diverges from the government’s target by more than one percentage point.
This was the first time the governor has had to take such action since the Bank was granted sole responsibility for monetary policy, a timely reminder that the battle to control inflation is never over. This development was a clear signal that the MPC, or any other economic policy maker, can not afford to be complacent.
As we move through August, the Bank of England Base Rate sits at 5.75 – a full one percentage point above last August’s figure.
On 27 June 2007, Gordon Brown officially became Prime Minister. While Brown has already started to introduce a wealth of new policies, he has been in charge of economic policy for the past 10 years so we are unlikely to see any radical changes. It is, however, probable that he will continue to keep a keen interest in economic affairs.
In terms of the rest of 2007, we are predicting another 25 basis point rise over the next few months, taking Base Rate to 6 per cent before the end of the year.
While further increases cannot be ruled out, a decline in inflation, a slowdown in economic activity and a continuing absence of evidence of a marked pick-up in wages, should prevent the need for rates to go much beyond 6 per cent.
Market impact
On the most basic of levels, an environment where interest rates are rising, as we have seen over recent months with five quarter point rises since last August, is likely to encourage home buyers to exercise more caution and thus lessen housing demand.
The natural next step would be for demand to fall causing house price inflation to ease, and that is what we have started to see over the past few months. Although house prices have continued to rise, the rate at which they are increasing is slowing.
House prices increased by 2 per cent in the second quarter of this year, less than the 3 per cent increase in the first three months of 2007 and well below the 4.2 per cent rise in the final quarter of last year. The average house price now lingers just below £200,000.
The average house price has almost doubled in the past five years, since 2002, when the average house price was around £100,000. When the Bank of England took control of the MPC in May 1997 the average house price was £64,056 and the Base Rate was at 6.25 per cent.
Just as there is evidence that house price inflation is slowing, the signs of a general slowing of the housing market are there also.
The Bank of England reports that net lending in May, at £9.5 billion, was lower than the previous six-month average. In terms of new people entering the market, latest figures from the Council of Mortgage Lenders (CML) reveal a fall in the number of first-time buyers in June.
According to the CML, the number of loans to first-time buyers declined to 35,600 – somewhat lower than the 39,800 loans in June last year. It is also the lowest June figure since 2004, when there were just 33,600 first-time buyers getting on the ladder.
Affordability is increasingly an issue. The first-time buyer income multiple hit a new record at 3.37 times the average first-time buyer income – up from 3.36 times in May, and 3.22 times in June last year.
Fixed rate popularity
The greater take-up of fixed rate mortgages is delaying the full impact of higher interest rates. The increase in the proportion of borrowers taking out a fixed rate mortgage in recent years appears to have affected the timing of the housing market’s response to interest rate changes.
As a result, house price inflation and activity are likely to take longer to slow as interest rates rise because many borrowers are only affected when their fixed rate deal matures.
Over the past 18 months, nearly 70 per cent of new mortgages have been taken out on fixed rate terms; substantially above the average of around 40 per cent since 1993.
The CML estimates that around 1.3 million borrowers took out fixed rate mortgages in 2005, and a further 1.5 million in 2006. The majority of these mortgages would have been fixed for two years.
A borrower with a £114,000 mortgage – the average in 2005 – taken out at the average two-year fixed rate in 2005 of 5.08 per cent, would be making monthly repayments of £669.02. When the deal expires this year, the new monthly repayments would be £733.72 – an increase of 10 per cent or £65 – assuming that the borrower moves onto the current average two-year fixed rate of 6.04 per cent.
In terms of how this will affect affordability, it is envisaged that most borrowers will be able to absorb the rise in payments. The estimated 2.8 million borrowers who took out a fixed rate mortgage in 2005 and 2006 account for around 25 per cent of all mortgage borrowers.
The overwhelming majority of these borrowers are expected to be able to absorb the increase in payments.
Most people’s earnings will have risen since they took out the mortgage – average earnings have risen by 7 per cent over the past two years in monetary terms – providing more income to finance the higher interest payments. In addition, most borrowers facing higher payments will have accumulated a significant cushion of housing equity as a result of house price inflation since they took out their mortgage.
Long-term fixes
The Chancellor recently called on lenders to ensure that longer term fixed rate mortgage products are more widely available.
Already the vast majority of lenders offer fixed rate deals, but it remains to be seen how popular these longer term deals will be and the impact they will have on the housing market and wider economy.
If there is a trend for people to fix for longer it could therefore mean that changes in the Bank of England Base Rate have a more drawn out impact on the housing market over the coming years.
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