Doves beat the hawks again as bank rate celebrates its second anninversary

Posted on 10 March 2011 by Drew

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It is abundantly clear from the recent speeches and other comments from several MPC members that there is more disagreement among its members than ever before. However, with the recently revised GDP figures for not only the last quarter of 2010, but also 2010 as a whole, being even worse than the initial estimates, the MPC members who have been calling for a rate increase need to give even more consideration to how much impact such a move would have on an economy that is at best stagnating.

In the short term the recent rise in the oil price, coupled with the much greater than usual short term uncertainty about the pricing impact of events in the major oil producing regions, increases the challenge facing the MPC. One must now expect inflation to peak even higher than looked likely only a month ago. However, the impact on consumer spending of higher pump prices is similar to the impact of higher interest rates and so for the MPC to impose an avoidable double whammy on consumers by increasing Bank Rate would make no sense.

The sharp drop in consumer confidence over the last few months, with more pain to come next month from the tax and benefit changes, suggests that any recovery to a positive GDP figure in the first quarter of 2011 will be marginal and that the oil price increase heightens the risk of not only a double dip but also of very weak GDP numbers for 2011 as a whole.

With this background it is hard to see the MPC increasing Bank Rate as quickly as the market is now expecting and indeed 5 year swap rates have eased back from a high of 3.23% last month to 3.00%, albeit after increasing from a low of 1.99% late last year. Mervyn King's recent comment that the market is getting ahead of itself was particularly noteworthy.

The cost of 5 year fixed rate mortgages has increased by nearly a full percentage point in the last 3 months, from a low of 3.69%, whilst variable rates have remained broadly unchanged. As a result the premium of around 2% one now has to pay for the security of a 5 year fixed rate looks too high, except for those who need, or just prefer, the security offered by a fixed rate. The 2% differential between the best 5 year fixes and the best variable rates at the same LTV means that Bank Rate will have to AVERAGE more than 2.5% over the next 5 years for the fixed rate to prove cheaper.

What should borrowers do now?

Rather than buy a fixed rate mortgage after the recent sharp rise in rates there is a strong argument for having a variable rate but overpaying by making a similar monthly payment to that which would be required on a 5 year fixed rate - say 4.5% - 5%. Most lenders allow overpayments of more than this amount without an early repayment charge being triggered and overpaying while rates remain low offers the twin benefits of reducing the mortgage balance, thus mitigating the impact of the higher payment required as rates rise, and softening the psychological blow when rates rise as there will be no need to increase monthly payments until after several Bank Rate increases.

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