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Is it the right time to raise interest rates?

Thursday 2 November has a thick red circle around it in my diary – and not just because it’s my son’s birthday. The economy beat expectations in the third quarter, which is likely to have sealed the deal for the first interest rate rise in a decade. We’ll find out if monetary policy changes on Thursday.

The UK economy is hardly firing on all cylinders, but it did grow more than the experts had forecast, expanding by 0.4% – 10 basis points higher than the three months to June. It’s also another sign that the economy is so far refusing to slip into a recession as many Brexit doomsayers had warned.

Britain’s services sector generates around 80% of the economy’s output, and it was the computer programming sector that gave the UK the extra boost it needed to claim its small victory.

As Brexit squabbling continues, it’s certainly reassuring that the economy is inching higher, but I’m unsure it gives the green light to this step change in monetary policy – especially when the rest of the economy isn’t in as fine fettle.

Unemployment is at record lows, but wage growth is stagnant – something that’s puzzling advocates of traditional economic theory. Productivity is trailing behind many other developed economies, personal debt is at worrying levels and there are big concerns over Brexit’s divorce from the EU.

Even though it’s growing, gross domestic product (GDP) is lagging behind many other major economies. Include the latest third-quarter figures to a performance analysis of the last 12 months and GDP has risen just 1.5% over the last year.

The US reported annualised growth of 3% in its third-quarter results this week, higher than expected.

Monetary policy

All signs are now pointing to a November rate rise, as the Bank of England tries to curb a painful acceleration in inflation and return to normal monetary policy.

By making debt more expensive, the Bank of England will be attempting to make spending slightly less attractive, to ease the momentum behind price rises.

Traditionally, higher interest rates lay the foundation for a good savings environment. But it will take time for a higher bank rate to feed into the returns offered on savings accounts, and this path to a normal monetary policy will be gradual.

There’s also questions about what the new normal will be; it will probably be much lower than it was before.

This means money sat waiting for decent returns in cash ISAs and other savings accounts will be gathering dust, at best. At worst, and more realistically, inflation will be eroding the purchasing power of your savings as price rises outpace the returns offered on cash savings accounts.

Is this the right time to raise interest rates?

When you take the time to separate the wheat from the chaff, you stumble on some interesting nuggets. This week’s came courtesy of the Reuters poll of expert economists.

Whilst most reckon the Bank of England will raise interest rates next week, the majority think this is the wrong time to do so – especially as the risk of a disorderly Brexit has now risen.

With consumer budgets feeling the squeeze from rising prices and stagnant wage growth, making debt more expensive will constrict household budgets further. Brits will have two options; stop spending or default on their loans – neither of which are good omens for economic health, especially with the debt landscape as it is.  

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Falling retail sales  

Brits are already cutting back on what they’re spending on food, furniture and in department stores.

Last month, more retailers reported falling sales than at any time since 2009, although they’re hoping it’s a one off and expect sales to bounce back in November.

With the Budget, Black Friday, a potential rate rise, and rocky Brexit negotiations ongoing, consumers could be in for a tough ride next month. Time will tell how the purse strings will react.  

What are other Central Banks doing?

If Carney increases the bank rate by 0.25% next week, he’ll only be reversing the decision he made to keep the economy ticking over after the referendum in 2016. Still, it will be a big sign of a changing mind set  at Threadneedle Street – although he won’t be the first Central Bank to start unwinding stimulus.

The US Fed has already started  slowly increasing rates and in Europe, the ECB has decided to extend its quantitative easing programme until September 2018, although it’s halved its asset purchase scheme to €30 billion a month. Interest rates will be kept at their record lows for some time to come.

Impact on financial markets

As it will take time for the returns offered on cash accounts to reflect higher bank rates, now isn’t the time to wave goodbye to the financial markets if you want to protect your money and grow it for the future.

To offset the impact of rising prices, you need to look for inflation-beating returns. You can hunt for these on the markets.

But what impact do higher interest rates have on financial  market investments? A rise in the bank rate will cause current bond prices to fall.

Investors want the best return money can buy – we know that. A rate rise will push the interest rates offered on new bonds, yet to be released, higher and investors are likely to wait for the better return.

A lack of demand for current bonds will cause their price to decline, until their rate of return looks attractive again to investors.  

Higher interest rates and an end to cheap money can also chip at the momentum behind stock markets, as it becomes more expensive for companies to borrow and spend.

However, with the main economies looking to return to a normal monetary policy there will be fewer places to go. A rate rise will probably put some oomph behind sterling, as it will be taken as a sign the economy is on the right track – although the pound might still not recover to its pre-referendum levels for some time.

Diversification will be an important tool in managing portfolio risk as economies move to normal monetary policy and Brexit negotiations continue. Spreading your money across geographies and asset classes mean you can hopefully offset any losses with gains from elsewhere in your portfolio.

It takes a steely set of nerves to hold your ground during short-term fluctuations – especially when they go on for longer than you would prefer. But a long-term horizon really is one of the most effective investment strategies to help you achieve  those goals of yours that are a few decades away.

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