Why interest rates will stay lower for longer

Tom Stevenson
Tom Stevenson
Fidelity Personal Investing14 September 2017

The Bank of England left interest rates at their 300-year low of 0.25% today despite a growing inflationary threat and another warning from Governor Mark Carney that the markets may be too complacent about the cost of borrowing.

The most obvious reason for the Bank to draw a line under the last nine years’ emergency monetary policy is the apparent return of inflation. It remains stubbornly above the Bank’s 2% target, this week hitting a five-year high of 2.9%. Increases in the cost of clothing and footwear were a notable feature of the latest data - up 4.6% month on month, the sharpest rate of growth since the Office for National Statistics started tracking the sector in 2006.

A further rise in inflation would force the Governor of the Bank of England to write to the Chancellor of the Exchequer explaining why he had allowed prices to rise so fast.

The Bank warned again that households and investors are probably underestimating how soon and how far interest rates could rise if inflation became entrenched. The central bank’s experts think that the British economy can no longer grow at the rate it did before the financial crisis without triggering further damaging price rises.

The Old Lady may be softening us up for a rate rise sometime soon but no-one really believes her. Here’s why:

  • Although input costs are rising on the back of sterling’s weakness since the EU referendum last year, this does not necessarily lead to higher prices for consumers. The reason for this is that the High Street remains an intensely competitive place. Companies may be choosing to swallow higher costs, accepting lower profits as the price for maintaining market share.
  • Secondly, stronger headline inflation is showing no sign yet of feeding through into higher wages. Although this week’s employment data showed the jobless rate at its lowest level for decades, wage growth remains subdued. Salaries are growing more slowly than prices and this by itself will act as a brake on the economy and keep a lid on inflation. This may change in the wake of the Government’s lifting of the public sector pay cap but so far there’s no evidence of a nascent wage-price spiral.
  • The third reason to expect the Bank to err on the side of caution is Brexit. As Jean-Claude Juncker at the European Commission this week warned Britain that it will come to regret leaving the EU, it is becoming increasingly clear that progress on the Brexit talks will be hard-earned and slow. The uncertainty caused by Brexit could drag on for years as we move into an open-ended transition period after March 2019.
  • The fourth reason is the persistent weakness in the economy. Car sales and consumer confidence both point to ‘underwhelming’ growth in the months ahead.
  • Finally, Mark Carney’s tag as the ‘boy who cried wolf’ on interest rates has diminished the power of his comments to move markets. He warned two years ago that Britain may be moving closer to a rate hike but then backtracked when the economy weakened.

The recent strength in the pound suggests that investors are taking seriously the threat of higher rates somewhat sooner than they expected. But at $1.33, the pound is still relatively weak by historical standards so the message from the currency market is hardly decisive.

The bond market is also pointing only half-heartedly towards a rate hike. The probability of a rise this year has reached one in three, according to the financial futures markets, which by definition means that it is more likely than not that rates will still be at an all-time low as we enter 2018. Two-year government bond yields (the most sensitive to changes in interest rates) stand at 0.29%, only just above the 0.25% base rate.

Today’s decision was the first since May to include nine monetary policy committee members. The 7-2 split suggests that the Bank is edging towards the first rate hike in a decade but remains some way off actually pulling the trigger.

What does this mean for savers and investors? As we have pointed out many times here before, it means that generating an income will remain a challenge. Sources of yield such as dividend-paying shares and some bonds will be underpinned by demand from income-hungry investors. Holding money in cash will continue to carry an effective opportunity cost, even if in uncertain markets it helps investors sleep at night.

No-one can predict the future. A balanced portfolio, including a healthy spread of assets from multiple geographies, with a mixture of growth and income-generating assets, and a sensible cash buffer in case of volatility, continues to make good sense.

The Select 50 includes a number of funds explicitly focused on generating a high and sustainable income. Here are three:

Invesco Perpetual European Equity Income Fund is run by Stephanie Butcher. She and her team conduct more than 400 meetings a year to find companies able to pay attractive and sustainable dividends.

Fidelity Global Dividend Fund, managed by Dan Roberts, is focused on both income and quality. Dan looks for companies that can really afford to pay their dividends. ‘It’s surprising how many managers don’t do this’ he says.

Clive Beagles’ JOHCM UK Equity Income Fund looks for companies which have the ability to grow their earnings and dividends over time as well as to pay a high dividend today.

Important information

The value of investments and the income from them can go down as well as up, so you may not get back what you invest. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment. The Select 50 is not a recommendation to buy or sell a fund. This information does not constitute investment advice and should not be used as the basis for any investment decision nor should it be treated as a recommendation for any investment. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. Fidelity Personal Investing does not give personal recommendations. If you are unsure about the suitability of an investment, you should speak to an authorised financial adviser.