An interest rate hike has been talked about in the UK media for quite a long time now. Today interest rates have gone up from 0.25% to 0.5%. Now that, on 2nd November 2017, interest rates have finally been raised after a period of 10 years, what does this mean for investors, particularly those eyeing financial independence. Further interest rate rises are expected, gradually, at the same 0.25% or 25 basis points step. Should we all panic, stay the course by maintaining our current strategies or tweak our future plans.
UK interest rate background
The interest rate, also known as the base rate is set by the Bank of England Monetary Policy Committee (MPC). MPC members meet eight times a year for three and a half day sessions in order to decide the base rate and vote accordingly.
The committee was established in 1997 and consists of nine members including the Bank of England Governor, Mark Carney. The interest rate has existed in many forms since 1664, ranging for 0.25% to 17%. The graph shows recent history of the rate.
As shown, the interest rate dropped dramatically following the 2008 financial crises and is currently at all time lows. Rates as high as 5.75% prevailed as recently as 2007. The rate remained relatively constant at 0.5% for from 2009 until a drop to 0.25% in 2016 due to concerns over Brexit.
Why the interest rate has been changed
There are many reasons for interest rates getting changed by central banks:
- To slow down or speed up the economy. Lowering rates can provide a short term boost, which may also be beneficial for political gain. Raising rates can be used to put the brakes on an overheating economy.
- Controlling inflation and consumption. Higher rates would result in consumers borrowing less and therefore spending less due to less credit being taken up.
- Higher interest rates van also be a result of an economy which is performing well. Strong economies tend to have higher interest rates and weaker economies the opposite.
- International trends. Some economies appear to be closely tied together. For example, the UK interest rate tends to generally follow the US Federal interest rate. With the US and Canada rates having gone up recently, we can expect the UK to follow suit.
Taking the above points into consideration, what can we learn from the UK interest rate hike. My take is that the bank wants to control the relatively high inflation rate (3%) and also tackle the high personal debt levels. Another reason is that the economy is doing relatively well, with unemployment at a low rate of 4.3% and the latest quarterly GDP growth of 0.4% compared to 0.3% in the previous quarter.
The recent boom in house prices has led to many borrowers taking on huge debts which may be unsustainable in future. It is possible that property prices may fall or rises may slow as some people struggle with higher mortgage payments. This rise in monthly payments would be a major milestone as this would break a trend of payments which have only been lowering for the past decade, with up to 8 million UK residents not having experienced a rate rise before.
Impact on investments
The interest rate hike should give investors more confidence and be considered as evidence that the economy is robust and strong earnings should be expected in future. Markets and currencies tend to become volatile when there is the slightest hint of a rate change. The best way to react is to stay the course and stick to tried and tested investment strategies as outlined on this blog.
Investors with diversified portfolios will also hold bonds as part of their asset allocation. Bond prices tend to have an inverse relationship with interest rates, therefore are expected to go down as the rate goes up. Bond yields are expected to increase as a result.
Cash savings accounts may benefit slightly with an increase in their interest rates. Due to very low returns, I am not a big fan of holding cash except for short term savings or as part of an emergency fund.
Focus on costs
Obviously, higher interest rates may reduce the cashflow for those with loans as their other payments will go up. This makes it even more prudent to use low cost investment vehicles. Focusing on costs is key and critical to investment success.
It is recommended to invest in low cost index funds to ensure that you get to keep as much of the returns as possible, which will in turn compound faster over the years. This will make achieving financial independence faster and increase the size of your portfolio.
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