Interest rate outlook - lower for longer
Over the past couple of months there has been an interesting development in financial markets
Despite continued forecasts of economic revival, expectations for the future interest rates have declined. Even a few months ago the investment market was discounting base rates moving gradually higher as recovery gained momentum, reaching perhaps 1.5 per cent by the end of 2010. Now views have changed and instead the consensus expects rates to stay ‘lower for longer’ and below 1 per cent for the rest of the year.
The reasons for this are the cumulative effect of a number of indicators, which together suggest that the upturn will be far from robust. Although estimates of growth in the fourth quarter were revised higher to +0.3 per cent, itself hardly a robust rate of expansion, much of the apparent improvement was due not to a stronger end to the year but rather due to the third quarter being weaker than previously thought.
In addition, and despite a 28 per cent decline in the value of the pound since the start of the credit crisis, UK exports remain weak and actually fell in January; our major trading partners in Europe are seeing little growth.
Against this lacklustre background investors are concerned that cuts in government spending, further increases in taxation and rising unemployment will all hold back the pace of the upturn, keeping growth so low that the recovery is vulnerable to external shocks with the risk of a double dip in activity a real one. This is an environment where base rates need to stay low and it is the reason why borrowing cost expectations have fallen.
Of course the consensus is only that, it isn’t guaranteed and a wise head will always consider the threats which could result in a future that is very different from that described above. In doing this prudent exercise we can see the threat of inflation.
At the moment it is expected to remain low, in the UK and overseas. But there are threats. The pronounced weakness of sterling has pushed imported goods prices sharply higher. In addition the vast amounts of liquidity injected by the government into the economy to stimulate activity must be withdrawn if it is not to spiral prices higher as conditions improves.
Author: John Kelly
John Kelly is head of client investment at CCLA.
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