What next for inflation and interest rates?


Business graph with one stack of coins. Studio shot

Both inflation and unemployment continue to fall, but the Bank of England says rates will remain on hold.

To coincide with his first quarterly Inflation Report back last August, Bank of England Governor Mark Carney set out 'forward guidance' on interest rates. Yet he's already been forced to change the benchmarks the bank's Monetary Policy Committee (MPC) will use to judge when it's the right time to raise rates.

So what happens now?

Forward guidance then...

The whole idea of forward guidance was to bring some stability to both businesses and households by offering some indication of when rates would rise. It was initially predicated on the rate of unemployment hitting 7%, so long as the annual rate of inflation (as measured by the Consumer
Prices Index) was within range of 2% and there was no looming financial catastrophe on the horizon.

The problem was that unemployment swiftly fell to 7.1% and inflation hit 2%. That prompted many commentators to speculate that a rate rise was imminent and risked undermining forward guidance as a concept.

For their part, Governor Carney and his fellow MPC members were quick to rebutt this idea. But it wouldn't go away, so it was back to the drawing board.

...and forward guidance now

In the just-released February Inflation Report, the Bank of England set out "further guidance" on what else would need to be happening once the unemployment rate was at 7% in order for rates to rise. The 7% milestone is now forecast to be this spring.

These additional benchmarks include: inflation being around the 2% target; the economy recovering in line with Government plans for growth and employment; and 'spare capacity', ie productivity, improving. And any rise in interest rates would be "gradual".

Yet all this could be thrown off course by "economic developments".

So you could argue that there is not much definitive forward guidance at all. But then no-one has a crystal ball...

Interest rate forecasts

The Treasury's most recent average of economic forecasts shows the overwhelming majority still expect rates to be at 0.5% at the end of this year.

In the Inflation Report, the Bank of England says that the money market forecasts interest rates to be around 2% in three years' time. It makes its own position slightly clearer, though, when it talks about rates being "materially below the 5% level set on average by the Committee prior to the crisis" even in 'normal' times.

So the 'new normal' would appear to be rates around the 2-3% mark in the medium term, providing things don't go drastically awry between now and then.

Indeed, at the Inflation Report press conference Governor Carney said: "We're still operating in quite exceptional circumstances". So a bit more potential wriggle room there...

Inflation forecasts

So what about inflation? Here's how annual inflation as measured by the Consumer Prices Index (CPI), the Government's favourite measure, has moved over the last four years:


Inflation rate

May 2010


November 2010


May 2011


November 2011


May 2012


November 2012


May 2013


December 2013


You can see from this table that inflation has been consistently higher than the 2% target, although it has been falling and finally hit the magic number in December 2013.

The Bank of England's own forecast is, on the balance of probability, inflation will stay around the 2% mark for a few years to come.

The Treasury's average of independent forecasts is still showing a figure of 2.3% for the final quarter of 2014.

What this means for our money

For people looking to take out a mortgage or remortgage, rates have potentially bottomed out. This is partly as a result of the focus of the Funding for Lending scheme, which offers cheap borrowing to banks and building societies, being shifted from mortgage lending to small business lending.

Having said that, it's still a good time to get a mortgage deal, particularly if you're planning on fixing your rate for a while.

The Bank of England's determination not to increases rates too soon is also good news for people already enjoying a low variable or tracker rate, as this is set to continue for a while yet. To see the latest mortgage rates, visit our mortgage comparison centre.

It's not good news for savers, and pensioners in particular, with the combination of low interest rates and inflation around 2% meaning rates on savings and annuities will continue to be poor.

However, the more longer-term outlook of this revised forward guidance that rates aren't going to rise swiftly any time soon means it might be worth considering fixed rate savings options again.

While instant access savings rates continue to nosedive, rates on fixed accounts have held up. If you haven't used your Cash ISA allowance for this tax year, you might want to look at that as your first port of call. Rates are similar, and in some cases better, than on savings accounts, with the added bonus of returns being tax free.

For a range of cash savings options with different levels of risk and returns, take a look at Where to earn most interest on your cash.

Alternatively, a continued low-interest environment might mean it's time to dip a toe into the stock market.

What do you think will happen to inflation and interest rates next? Where are you putting your money? Share your thoughts in the Comments box below.

12 ways to save £10,000 in 2014

12 ways to save £10,000 in 2014