Current Bank of England Interest Rates

Historically (since 1694) the BoE Interest Rate has never fallen below 2% and between 1694 and present day, the long term average rate has been 6%. The graph below shows the BoE Interest Rate over the last 30 years. For mortgage borrowers, with the recent 0.25% fall in the BoE interest rate, the rate is at a relatively low 5.00%, compared to the long term average. This currently makes it easier to afford the interest payments for a mortgage compared to the 1980's and 1990's..

However, when we are living in a relatively low inflation environment it means your debt is not shrinking as fast in real terms. Back in the early 1980's and early 1990's when interest rates went around 12% to 15% we also had high inflation, so a mortgage loan was effectively shrinking faster in terms of moneys purchasing power. At the moment debt is only shrinking at around 4% per year due to inflation.

Also, as first time buyers will be aware, having low interest rates which makes interest easier to pay, isn't much help when the property prices are so high in the first place. The interest per month may be a relatively small proportion of mortgage value, but large mortgages still mean large monthly payments. The problem is that property prices have been rising faster than wage increases, meaning that although the interest rate for a mortgage loan is relatively low, the amount of loan needed to purchase an average property has shot up without the average persons 'ability to pay' increasing by the same proportion

Now, just because the BoE have lowered base rates for the third time in about 6 months doesn't mean to say that inflation is not still a threat. Oil prices are still high (you may have noticed that a litre of petrol/diesel has now breached the £1 barrier). Energy prices in general are higher than they were a few years ago, although the current mild weather we are experiencing may help to keep a lid on gas prices over the winter.. However we still have the potential geo-political effects of Russia and the Middle East, both of which control a huge portion of our current raw energy imports, and with both situations open to further deteriorate. 

The UK property market is already slowing down, with a recent report indicating that most property values in the UK may stagnate or drift down slightly in the near term. There is also the effect of the current credit crunch to deal with. Although the sub-prime mortgage market in the UK is only a few percent of the total market, and therefore should seem to have only a limited effect on lending in the UK, the negative sentiment towards mortgage backed investments is now such that most if not all  investors are no longer interested in investing in further packages of mortgage debt until they've worked out their positions on the 'investments' they already hold.  

This means that lenders who rely on being able to package and sell their mortgage books in order to recycle money for further lending are now finding it difficult to raise enough money to continue trading, as is the case with some specialist lenders in the UK. Lenders who operate business models which rely on this type of money recycling will either have to change their business model or get out of the industry until sentiment improves, which could take many months if not a number of years.

We also have the situation now where it is still not yet clear how much bad debt lending institutes will have to write-off due to foolish investment in risky debt. As such, no bank wants to lend money to another bank, because they're all waiting for the next weakest bank to fail (as Northern Rock did) and they're not sure who it will be. As a result there is no trust left between banks and lending institutes, and since a debt economy is built entirely on trust (i.e. the promise to repay), it's difficult to see how this trust will be regained until all banks, investment and lending institutes have reported a couple of times and shown no further problems. This will take at least the remainder of 2008 to get to a point where bank analysts are fairly confident all the skeletons are out of the closet.

In essence many lenders will probably have to revert to a more traditional ways of raising money from their existing customers. They are already tightening their lending criteria to avoid taking on any more risk until the current risks have been properly determined. There are no longer any 100% + mortgages available in the market place, and although this will create difficulties for some borrowers in the short term, it has to be a good thing for the security and confidence in the financial economy to get back to a more realistic assessment of risk However it does mean that the traditional links between the BoE interest rate and a lenders base rate is beginning to break down. Don't expect lenders to pass on all interest rate cuts to borrowers in the short term, but do expect interest rate cuts to savers to flow through pretty quickly.

It will probably take until the end of 2008 for the cost of the credit crunch to lenders to become clear and until then obtaining mortgages and loans will become more difficult for those people with credit problems. In the meantime, it seems as though this credit crunch has raised the spectre of recession in both the USA and hear in the UK, with some commentators believing that the US has already entered recession.

These various issues mean we will continue having uncertainty in the economy, with the BoE  treading an ever finer line between trying to boost the economy to avoid recession and improve investor sentiment, but without encouraging inflation, which is only just back to near-target levels. Definitely time to 'batten down the hatches'!

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