In June 2007 Mervyn King, governor of the Bank of England (BoE), and four members of his Monetary Policy Committee (MPC) voted for a quarterpoint rise in interest rates. They were outvoted. Only just - defeated by one vote. Remarkably, this was only the second time that the hawkish governor found himself on the losing side of the BoE's monthly rate decision. The majority of analysts responded with an overall view that the tight vote increased the likelihood of a further rate rise for July. And they were right.
Another rate rise has taken the base rate to 5.75 per cent. Some predict at least one more rise before the end of this year, so it's more important than ever that investors understand the background to this control mechanism and its rationale.
Why are interest rate rises necessary?
The BoE uses rate rises as an instrument for damping down inflation so that the economy can grow steadily without the damaging fallout seen in past inflationary periods.
So far, the BoE's rate increases appear to have worked. In April this year, consumer price inflation (based on the Consumer Price Index - the CPI) stood at 2.8 per cent; by May, it had fallen to 2.5 per cent - which may sound like excellent progress; but even a fraction of a percentage is too high for this complex book-balancing act. King himself pointed out: "The contribution of domestic energy price inflation is set to fall sharply over the rest of this year. but the overall path of CPI inflation depends on what happens to other prices."
Higher borrowing costs do not, in the BoE's opinion, adversely affect growth. But "other prices" are clearly of considerable significance. Among these, of course, are wages and benefits. These are pegged not to the CPI but to the Retail Prices Index (RPI), which includes housing costs.
The RPI currently stands at an alarming 4.8 per cent: the highest rate since 1991. Much depends upon pay negotiations over the second half of the year. If employers and workers agree pay rises well above inflation, the RPI could increase. Any advantages to be gained from higher salaries would promptly be cancelled out by commensurate increases in the cost of living.
Currently, the BoE is forecasting - and aiming for - two per cent inflation in two years' time. While the recent base rate increase may affect you quickly - higher prices in the shops; perhaps an increment in your mortgage payments - it normally takes more than a year for interest rates to have an impact on inflation.
What are the effects of these rises?
The effects of rises are to push up the cost of both debt and investments (which could hurt some companies and endanger some jobs), and to boost the value of the pound against the US dollar. The latter has both positive and negative outcomes: while it helps to keep down the price of energy (which tends to be priced in dollars), companies exporting to the US find their margins squeezed. Still, it's worth remembering that interest rates are still far below those seen in the late 1980s and early '90s.
But what of the housing market? An increase of another quarter per cent is unlikely to cause a crash, however there will be regional variations reflecting levels of demand and their impact on values. For example, the London market continues to occupy a league of its own due to foreign investors, tax-avoiding foreign residents and City bonuses.
At the same time, first-time buyers and low earners will continue to find it increasingly difficult to get on to the property ladder. An increase in repossessions is likely. Obviously, neither of these two misfortunes bring bad news to the buy to let property investor. Investors can only benefit from a constant supply of tenants combined with more opportunities for snapping up bargains.
Add to these factors what we already know about the UK population's constant enlargement and the continuing shortage of housing stock, and you have a picture that is reasonably rosy for the careful investor who keeps a keen eye on cash flow.
As ever, levels of debt and cash flow govern an investor's success. Data from the Council of Mortgage Lenders reveals an interesting trend in this respect: the proportion of buy to let mortgages three months or more in arrears (a useful diagnostic tool for investor health) is continuing to fall. In the wider mortgage market, the figure stands at 0.89 per cent; in buy to let, the figure for the first half of 2006 was 0.64 per cent, which had fallen to 0.59 per cent by the end of the year.
We started with King, so we will let him have the last word: "Excessive leverage is the common theme of many financial crises in the past." This principle applies equally to the property investor, who must ensure debt levels are manageable in order to succeed.
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