Will rising inflation push up interest rates

The recession might be technically almost over but donít think that means your financial situation will get better any time soon.

According to the bank of England Governor, Mervyn King, ìthe patience of UK households is likely to be sorely tried over the next couple of yearsî.

Thatís not the sort of comment that will please the government, which is doing its best to convince us that the future is looking rosy.

But itís important for all of us to realise that it is the Bank of Englandís main job to adjust interest rates to keep inflation under control.

And thatís the problem. While the credit crunch may be easing, the money the government bailed the high street banks out with and a recovering worldwide economy is increasing money supply and this in turn, is pushing up commodity prices and inflation.

Newly-released figures show inflation rocketed by a full 1% in December, pushing up the Consumer Price Index ñ the principal inflation figure ñ up to 2.9%.

Compared to the double-digit inflation figures we suffered in the 1970s, that doesnít seem too bad. Unfortunately, Mr King reckons we will see inflation exceed 3% in the months ahead. The main problem, however, is that with salaries at a standstill as companies try to keep costs under control, inflation is now rising twice as fast as average pay.

The latest inflation figures also donít take into account that VAT reverted back to its previous rate of 17.5% in January. Also, regardless of who wins the election in May, weíve been promised drastic cuts in public spending and big tax rises in order to get public finances back under control.

So, given that thereís no question we are all – as Mr King has promised ñ going to be poorer in the months and years ahead, taking care of finances has never been more urgent.

Regardless of whether you are a saver or a borrower, the extent to which inflation increases is the vital element we need to know in order to make the right decisions, as interest rates will have to go up if inflation continues to rise.

If you are a saver and you believe inflation will continue to rise, it makes sense not to tie your money into savings bonds now as you will miss out on higher rates in the near future. Likewise, if you have a mortgage, the question you should be asking yourself is whether it would be best to switch to a fixed rate now and pay a little more per month than on a variable rate, or take the risk of inflation and interest rates staying relatively low.

Unfortunately no-one has a crystal ball. But we do have the next best thing ñ economic expertsí views on what they think will happen.

Although weíve already heard the Bank of England Governorís warning that we face a tough time ahead, we need to listen carefully to exactly what he said. After all, he and the members of his Monetary Policy Committee are one ones who actually decide whether to raise or lower rates, regardless of what other economists think.

Mr King isnít suggesting that inflation will rocket. What he said was: ìIt is clear that inflation is likely to pick up markedly in the first half of this year. The CPI inflation is likely to rise to over three per cent for a while, or even higher for even longer were energy prices or indirect taxes to increase further.î

Simon Ward, chief economist fund managers Henderson New Star, reckons interest rates may have to rise as early as this Spring and thinks Mr King has been too relaxed about the perils of rising inflation.

He said: ìWe could see a move in rates this Spring. If GDP (economic growth) disappoints then my forecast could be off, but if it shows reasonable growth and inflation numbers keep picking up, everything could be lined up for a raise in April.
Ward predicts the base rate will rise a whopping 2% to 2.5% by August and stay at around that level through 2011

Ray Boulger of mortgage brokers, John Charcol, is a well-known commentator on interest rates. Unlike Simon Ward, he thinks the base rate will stay at 0.5% throughout 2010 and from then on gradually rise to 2% in 2013.

Simon Rubinsohn, chief economist at the Royal Institution of Chartered Surveyors, reckons base rates will rise to a modest 1.5% by the year end and creep up to 2% by the end of 2011. He said: ìThe Bank of England will be reluctant to pull the trigger and raise rates. We are entering a period when interest rates will generally remain low. The lack of available finance will mean that even if we have a strong quarter of growth or even a full year, the Bank will be deterred from raising rates.î

Simon Ward is an exception. But right now, it seems most economists arenít convinced of a rapid increase in the base rate.

Decemberís spike in inflation might just be a one-off nasty surprise, but the mere fact that it did come out of the blue is a warning for all of us of the need to keep a careful eye on future inflation figures.

Be prepared to move very quickly to switch to a fixed rate mortgage or a variable rate savings account if increasing inflation looks like becoming a trend.

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