Unless you happen to have a time-travelling DeLorean parked in your garage then the simple answer is no one really knows for sure what interest rates will do. However, we do know at some point interest rates will change.
It is the responsibility of the Bank of England, Federal Reserve and European Central Bank to keep their respective economies ‘just right’ (as in the Goldilocks scenario) – if the economy, ‘porridge’ runs too hot or too cold, we are likely to see changes to interest rates to remedy it.
Simply put, interest rates are generally lowered to stimulate economic growth by making it much cheaper to borrow money, which in-turn makes it a more advantageous time to spend. This could be by investing in physical assets, such as home improvements or that new luxury item, or increasing your financial assets by adding to your investment portfolio. In contrast, interest rates could be raised to prevent an economy from overheating.
The current central bank rates for our three major currencies are: UK 0.1%, US 0.25% and EU -0.5%*, which were more recently lowered in response to COVID-19 to help control the impact the pandemic would have on the economy.
What could bring about a change?
Four main things that could influence interest rates are:
If the rate of inflation was to rise quickly, the central banks’ response would likely be to raise interest rates.
2. Post-pandemic economic growth
Strong economic growth would increase the chance of an interest rate rise. If an economy grows faster than it can sustain, companies may increase their prices as they struggle to keep up with demand from consumers, directly affecting inflation.
High levels of unemployment can result in a slow-moving economy that could keep interest rates lower for longer, as fewer people are likely have disposable income.
Any new variants that our current vaccinations cannot protect us against could lead to further lockdowns and restrictions while new vaccines are developed. This would mean interest rates would be unlikely to rise and could even fall further.
The main drivers for changes to interest rates will be a rising inflation rate and a fall in unemployment figures. However, the central banks have indicated that the higher levels of inflation currently being seen are transitionary and so they have left interest rates on hold, for the time being at least.
Although vaccination programmes have allowed governments to ease restrictions imposed during the pandemic, it will be a little while before we see the true impact this has had on the economy. Economic activity looks to be recovering, but there is still some way to go. Before we see interest rates rise, we will likely see a tapering of the various quantitative easing programmes, whereby a central bank increases the supply of money by buying government bonds and other securities to encourage lending and investing.
What about investors?
Your views on low and high interest rates will vary depending on whether you are a saver, a borrower or an investor. Broadly speaking, those looking to spend or borrow will benefit from low interest rates, but savers will see them as a curse.
For an investor, a low-interest rate environment usually opens up opportunities for equity investing, but will bring challenges to those who are looking for reasonable returns through fixed income investments. The key is to have a well-diversified portfolio that invests across different asset classes, which can help to mitigate the impact of short-term interest rate changes and focus on achieving your goals over the longer term.
If interest rates remain lower than the current inflation rate, your cash savings will be eroded over time so it pays to explore other options for protecting your capital and making adequate returns. As Dr Emmit Brown said in Back to the Future, “Your future is whatever you make it. So make it a good one.” Although you may not be able to take a DeLorean for a spin into the future, you can work with an experienced financial professional to define your future financial goals to help you plan the most effective strategy to meet them.
At a time of much uncertainty across many aspects of our lives we may have to roll with the punches for some time yet, and wait to see what is in store around the next corner.
* ECB (Deposit Rate) -0.5%
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