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Are interest rates about to rise?

Interest rates: they impact what we pay on our mortgage and what we receive from our bank, and they’re currently at historic lows. It’s painful, you want to save but the returns you get barely touch inflation, and if inflation rises further, which it is expected to do, it’s even harder to protect your hard-earned savings.

But this week the papers have been talking about rising interest rates. The US Federal Reserve Open Markets Committee (usually just referred to as “the Fed” in the newspapers) meets on 17 March to discuss interest rates. Expectations for an interest rates hike in March are steadily rising, this is partly due to rising inflation expectations.

Rising inflation

Headline consumer inflation in the US now sits at 2.5%, above the Fed’s 2% target. If you look at the five year five year forward for US inflation (a market measure of long-term inflation expectations) you can see that long-term inflation expectations are drifting downwards. This suggests that markets expect the Fed to be quite successful in curbing inflation over the long-term.

As the Fed raises interest rates towards a more “normal” level, it raises the question of what “normal” actually means.  There’s a view that the normal (so-called equilibrium) level of interest rates will be lower in the future than it has been in the past. In other words, the US economy might respond more quickly to higher interest rates than in the past.

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Is the interest rate going to rise on my cash account?

Currently interest rates on bank accounts are rather low and this partly reflects the 0.25% Bank of England base rate. With the best cash ISA offering 1.05% according to Money Saving Expert, you’re ultimately losing value against the current 1.8% inflation. If you’re saving, inflation should be used as your benchmark.

From an economic perspective there are two reasons you might keep your money in a cash account:

  1. You think financial markets might be overvalued so cash looks more favourable.
  2. Interest rates are about to normalise so you’ll start earning money again.

Looking to what is happening in the US, interest rates could start to normalise the economy at a lower level than we’ve been used to. So we might be looking at a situation where interest rates never come back to where they once were.

This isn’t the doom and gloom story we might think it is though. Yes, we might have to turn our backs on the cash ISA forever, but there are still tax savings to be made from a stocks and shares ISA. This could be a new economic order where it’s cheaper to borrow money, making mortgages and student loans more affordable. With student loans where they are currently, and my children still about ten years from starting the application process, lower interest rates don’t look as terrible as one might think, provided you’re prepared to look to the markets and consider investing.

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