UK Interest rates are basically being kept down by hope…
Posted by markharrison on June 19, 2008
There’s a lot of debate raging in the blogosphere at the moment about where interest rates should be.
Some of the arguments are, (like this one by William Buiter of the FT) to put it mildly, very technical.
Basically, though, there are two schools of though:
- We should set interest rates based on what we know about the present
- We should set interest rates based on what we believe about the future
There is something called the Taylor Rule (see here) which is broadly accepted by economists as “what you should do if you want to base your decisions on the present”.
Now for the bad news – if we apply the Rule to the UK, we see that Base Rates should go up to about 7% – which would imply that investors were paying about 8.5% for their mortgages, and home-owners a little less.
However, the Bank of England clearly don’t want to do this – because (among other things) of the knock-on effect it would have on the cash-flow of most of the UK’s working population. Instead, they are basing their interest rates on the Treasury’s predictions of the future…
… which is to say that 2008 will be a ghastly year for, well, everyone… but that 2009 will be a lot better, with rates being a bit LOWER than they are now.
I find it interesting that the fact that you have to pay a LOT more than the base rate to get a mortgage actually suggests that the “markets” believe that rates should be higher than they are now (and the jump to fixed rates suggests that the markets believe that rates will go higher.)
Photo copyright Katie Tegtmeyer – used under a Creative Commons licence.