The Impact of the UK Economy on UK Interest Rates

Ultimately the Bank of England UK interest rates, LIBOR (and hence mortgage rates) depends on the UK economy which of course is also influenced by the world economy. The key economic factors affecting UK interest rates are factors such as inflation, Gross Domestic Product (GDP) growth, and government borrowing requirements. We are also influenced by the Global economy - our ability to import and export to other countries, and our ability to ship goods around the world, which is often determined by currency exchange rates.

The Governments influence on the UK Economy

Over the last few years the current Government has consistently overestimated GDP growth. Every 0.5% error means the Chancellor has to find billions of pounds to plug the holes in his budget. The interest rate cut in the summer of 2007 indicated that the economy was heading into a downturn, as did the almost continuous high street retailer 'Sales' which don't seem to have stopped, and over the last four months have gone into overdrive. Now that we have the credit crunch biting hard not only in the UK but around the World, the economy has definitely reached recession.

Economic growth in 2006 was somewhat short of the 3.5% the ex-Chancellor predicted (i.e. needed to make his books balance). The ex-Chancellor reduced growth expectations for 2007, and the new Chancellor has tended to be a bit more cautious, but still predicted growth of around 2%, even with recession looming. Most economic commentators predicted the UK economy to slow in 2008 and are predicting a worse slow down for 2009, so as usual the Chancellor has been optimistic in his forecasting. We also have the recent bank bailouts and other economic stimuli which the government has announced, driving up Government borrowing far higher than anticipate only a year ago.

So the books will still need balancing. This means that either spending plans must be cut on the NHS, Education, Transport and so on, or taxes must rise again, neither of which is good for keeping voters happy which is probably why the much vaunted 2007 pre-Christmas election was 'cancelled'. The only other alternative was for the Government to borrow large amounts of money, to add to the growing mountain of government debt, which is the option they've chosen.

We have the the UK bank bail out to pay for, with £50 billion on the table straight away, and potentially liabilities for much larger amounts being made available, all from the taxpayers purse. In the Prime Ministers Labour Conference speech he made all sorts of wonderful promises of the new 'New Deal' for Britain, but without once indicating how it would be paid for. Forgive my cynicism, but when the financial system is collapsing and the economy is in recession, it would seem 'prudent' to stop spending money we haven't got, rather than to borrow and continue spending even more. There's the old saying that if you owe the bank £1000 then that's your problem, but if you owe the bank £100 million then it's their problem. This seems to be the game the Government is playing with the tax payer.

So we may be looking at higher taxes either directly or more likely as stealth taxes which the ex-Chancellor was rather fond of. In 2005 the ex-Chancellor was accused of 'fiddling the books' in order to make his budget stay closer to the targets he set. This was probably not a good approach especially in the light of the reduced expectation of economic growth. If economic growth stays around the same low level for the next year or two, the current Chancellor will still not be able to balance his budget even after the ex-Chancellor redefined the economic cycle period to suit his requirements.

One of the ways in which the Government could make their debt (and as a result all borrowers debt) shrink a little faster is to relax inflation targets. Higher inflation would help reduce that excess Government debt more quickly in real terms. Are we now likely to see a more relaxed view of inflation targets? This is what the US has been doing recently; allowing their currency to weaken, so effectively making imports more expensive and hence raising US inflation on foreign imports but making it easier for US companies to compete in the US market. Over the last couple of years the UK currency has been strong, but this year we are now see a weakening of the Pound which is improving the outlook for UK exports.

One other factor in favour of relaxing the inflation target is that deflation is generally regarded as worse for the economy than inflation. This is because during a long term deflationary environment, such as in Japan over the last decade and a half, companies don't wants to invest because it will be cheaper to do so 'next week/month/year', and savers don't want to save (at least with traditional savings accounts or investments) because the central bank reduces interest rates which reduces savings rates. The Bank of Japan interest rates in Japan in April 2003 were a mere 0.07% (the decimal point is in the right place!) and is still very low, even now. In this kind of environment both the consumer and business just stops spending or investing in 'paper' assets because prices might be lower 'next week/month/year', and so the economy just grinds to a halt and is hard to kick start again.

UK consumers have over £1trillion of personal debt and very shortly the Government (i.e. taxpayer) will also have £1trillion of debt. The consumer debt is now just beginning to unwind with bankruptcies and repossessions on the increase, while the Government debt is on the increase. A large proportion of this UK consumer debt is mortgage debt which is still largely offset by the overall equity held in property, but a reasonable chunk of the debt is unsecured debt such as credit card and unsecured loans. The UK consumer is now starting to tighten their belts as first inflationary effects of energy and living costs, and now economic recession begins to bite hard.