How high will interest rates go?

Interest rates went up again, to 5.75%, last week. That’s the fifth rise in twelve months, taking the rate up from 4.5% to its current rate, which is the highest level since March 2001. This has heaped misery onto homeowners in particular who have suffered from rising mortgage rates as a result.

Bank of England Governor Mervyn King warned before the latest rate rise that failure to put the rate up in June might result in rates rises beyond the one we have just had in July. It was a clear signal that a 6% rate might be needed.

Earlier this week Malcolm Harris, CEO of Bovis Homes, suggested that the housing market to grind to a halt if rates were pushed up any further and the shares of housebuilders took a tumble after Bovis’s forecasts for the rest of the year.

Is the rate rise misery over? Or will it get worse? What do the experts think?

Simon Ward of New Star correctly forecast the rate rise in January 2007, and he thinks that the MPC will hold rates until October to see what the impact of the last two rises has been. If the result are positive from their viewpoint, i.e. inflation is held in check and house prices are stabilised then Simon Ward thinks rates might be held to the end of the year, but the biggest risk is the reaction of wages to the labour market.

Peter Spencer of Ernst & Young feels that it is hard to be confident that 6% will be the peak as the M4 measure of money supply is still rising too fast. His thinking is that rates might have to rise again, and they certainly won’t be coming down in the near future.

The view from Alan Castle at Lehman Brothers is that the market will begin to price in the probability of a rise to 6.25%, but that should be the peak. He expects 6.25% to be reached at the November meeting of the Bank’s Monetary Policy Committee (MPC) and for them to remain unchanged throughout 2008.

Overall the general view of economists and fund managers is that 6% is highly likely by the end of the year, but that the MPC will wait at least two months (until October) to see if their recent changes have had the desired effect. Remember that their only target is to steer inflation towards the government’s target of 2%. They will also watch for the M4 measure of money supply, consumer spending and house prices. However, they cannot take into consideration the number of mortgage defaulters, or repossessions, or bankruptcies or IVAs. The Bank’s message is also that it would rather provoke an economic slowdown than preside over a prolonged spike in inflation.

A rate of 6% has not been seen since January 2001, and many economists and industrialists feel that 5.75% is high enough before there is a negative impact on the economy, but the Bank needs to get inflation back down to 2%.

David Brown of Bear Stearns does not believe that the recent rise will be the last in the current round. He says that UK growth is probably too strong currently with domestic and credit demand running to high. These effects are fuel to inflation.

Chris Iggo of Axa Investment Management thinks that UK growth will slow in the second half of 2007 as the rate rise really start to bite. Other factors like higher fuel and energy prices, together with the depressing bad weather are likely to reduce consumer spending. Even better news is that headline inflation has been going down since March. Iggo believes that the MPC will hold rates to wait and see. If 6% is reached, he believes that the first half of 2008 will see them come down again.

UK consumers have been hurt by the rises, but latest reports suggest that they are still buying on the high street. Like-for-like retail sales were up 3% in June compared with twelve months earlier, and total sales were up by 5.1% over the year. Much of the gains have apparently been in homeware and furniture, spurred on by discounts, but sales were hit for clothing, footwear, DIY and gardening – undoubtedly by the poor weather in the month. The figures suggest consumer resilience in spending. However, the Bank of England is keen to moderate consumer spending to try and peg back inflation, so it is likely to be unimpressed by these latest figures.

The Bank may be rather more pleased by figures that show factory gate price inflation held steady in June, an indication that companies are not raising their prices despite costs going up for the fifth consecutive month.

The bottom line would appear to be that 6% rates are still expected by the end of the year, probably in October of November. That, as long as the signals are good after that, should represent the peak for this cycle.