Inflation… the last piece?

Rising interest rates. This is on the mind of every investor with money in the stock or bond market. When will they rise? By how much? What effect will this have on my portfolio?

There are currently three things that affect the interest rate benchmark in the UK, as set out by the Bank of England Monetary Policy Committee.

1. Inflation rates. Current CPI (consumer prices index) is sitting at 1.5%. This is below the symmetrical guidance mark of 2% (i.e. inflation below 2% is just as bad as inflation above 2%). This correlates to cheaper prices for consumers, but is not necessarily a good thing.

2. GDP growth. Since the financial crisis central banks have taken on more responsibility to keep our economy growing. This has resulted in low interest rates and QE measures to help bolster consumer spending. With UK GDP currently averaging 3.5% growth in 2014 we are the strongest growing economy in the G7.

3. Jobs. Mark Carney set out in his mandate, as the new BoE governor, that he would not raise interest rates until 750,000 new jobs are made (roughly reaching a 6% unemployment figure). Latest figures show unemployment at 6.2% suggesting good progress towards this target.

GDP growth is high, Job growth is improving and arguably reaching the BoE target, so why haven’t interest rates risen?

The last piece of the puzzle is low inflation. The MPC’s main target is to maintain level and stable inflation. With inflation below 2% it would be difficult to raise interest rates without risking a drop into deflation.

Scotland
Scottish independence might have a part to play in this. It has been argued that the £/$ could drop 10% to as low as 1.45 if Scotland get independence. This severely weakened pound would make imports more expensive and raise the inflation rate in the UK. Assuming our economy continues to remain strong, this could trigger the needed push for the BoE to raise interest rates, ensuring inflation remains stable at the 2% mark.

Pack mentality
However, it would be extremely bold for the BoE to raise interest rates before any of the other main economies. This is because the consequent currency appreciation (investors desperate for yield would flock to a strong economy with higher interest rates) would make exports more expensive and possibly hinder our economic growth. Morgan Stanley’s global analyst describes this as ‘breaking away from the peloton‘.

However, with Scottish independence and a weakened pound, currency appreciation may not be a totally bad thing. The pound reached heights of £/$ 1.70 this summer and we haven’t seen any kind of apocalypse so far.

A stronger currency would also be gratefully accepted for my bank balance, as I set out to study for the year in America.

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