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Interest rates are returning to the old normal

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Is it only five months since I warned in these columns that interest rates would go up and up?

The Bank of England had then just raised Bank rate to 1 per cent. Now it stands at 3 per cent, following Thursday’s 0.75 percentage point increase, the eighth increase in succession.

Our third prime minister this year, and our fourth chancellor, are striving to put together a coherent fiscal plan that will help control inflation and reduce the pressure for yet more rate rises. But few experts think that the latest increase will be the last.

We are heading for the old normal far sooner than even I expected. And it will change our lives.

When Jeremy Hunt presents his Autumn Statement on 17 November he will announce what he has called “eye-wateringly difficult” decisions (don’t confuse that dampness around the eyes with tears). Tax rises and spending cuts designed to assure the markets that what some Conservative MPs have called the return of the adults will also mean a return to fiscal stability. But that will not mean a return to miniscule interest rates.

Mortgage rates are between 5 per cent and 6 per cent, government borrowing costs nearly 4 per cent, with little prospect of an early easing: the Bank of England now expects Bank Rate to peak at 5.25 per cent in the third quarter of 2023.

Line chart of Bank of England interest rate (%) showing The BoE has announced its biggest interest rate rise in more than 30 years

As for inflation, it looks set to be high for some time. The past may be no guide to the future but the last time the Retail Prices Index (the only measure we had then) rose through its present level of 12.6 per cent in July 1979 it stayed in double figures for more than two and a half years .

There was no Consumer Prices Index then — the headline figure used today, which is currently 10.1 per cent. But the boffins at the Office for National Statistics have back-calculated it and that too rose into double figures in July 1979 and stayed there until February 1982.

One strange effect of the rapid rise in the cost of borrowing — gleefully passed on by the high street banks as their third quarter results have shown — has been that the return paid on cash exceeds that on shares. With their value plunging — the FTSE All Share index is down over 8 per cent since the start of the year — the yield from equities in the form of dividends has risen to 4 percent.

But there is now a risk-free option to get a one-year return of 4.6 per cent with RCI Bank and a five-year annual return of 5.05 per cent with Close Brothers in their fixed-term savings accounts. The deposit is not at risk provided it is divided up into £85,000 parcels and so covered by official guarantees.

Even National Savings & Investments is paying 1.8 per cent on its Income Bond and 1.75 per cent tax-free in its individual savings account (Isa). Money with NS&I is safe to any amount up to the NS&I investment ceiling — for example, £2mn in its Income Bond. Short-term safety and certainty is now found in cash. At the latest count in April more than a million people had the maximum £50,000 in premium bonds which now pay prizes worth 2.2 per cent tax-free — though if you discount the big ones, which you will normally not win in a lifetime, the average return is 2 per cent. An extraordinary £100bn was held that month by those with more than £20,000 bonds out of a total of £117bn in bonds. The maximum is per person so couples can have £50,000 each and put up to £50,000 each into earmarked accounts for children or grandchildren.

And what of mortgages? A colleague in his forties told me he was afraid of what his monthly payments might be when his fix runs out in 2025. “Higher,” I replied, perhaps £425 a month higher which the Resolution Foundation says is the average rise facing 5mn mortgaging households by the end of 2024.

I felt his pain — and a close relative in his forties said much the same to me just this week. But I did respond by saying that although these rises are not what you are used to and can be frightening, in my view they are inevitable. Before 2009, only one major modern economy — Japan — functioned long term with interest rates as low as 1 per cent or even 2 per cent. Investors want to generate a minimum return greater than or equal to inflation, otherwise, their savings drop in value and preferably greater than inflation and output growth combined.

Until the global financial crash in 2008, the Bank rate had averaged 4.8 per cent since the Bank of England was founded in 1694, and even with the nano-rates of the past few years the figure is still above 4.6 per cent.

So the Bank rate is heading back to where it should be and although mortgage rates are influenced by other factors it does not seem unreasonable for them to be at 5 per cent to 6 per cent. After all, banks have to make a profit on lending, including from the margin between the rates at which they raise funds and the rates they charge.

Rates like this are not the new normal — they are just the old normal. At the start of the century, average mortgage rates by building societies were 6.8 per cent falling to about 5.7 per cent just before the global financial crash. And the last time inflation was where it is today, mortgage rates were in double figures too.

Some good may come out of the old normal. It may give us the perfect opportunity to change the way mortgages are sold. What is the point of remortgaging every two or five years if there is no low rate to lock into?

At the moment there is a conflict of interest between mortgage brokers and their clients. If they sell a five-year or, better, a two-year deal they get regular commission from remortgaging. But if they sell a variable rate deal with no temporary discount the client may not be back, if at all, until they move — on average only once every 23 years, research by property website Zoopla found in 2017.

It is a conflict not found, for example, in the US where 30-year fixes are common or in Germany where the typical mortgage deal covers 25 or 30 years, often with rates fixed for 10 years and up to 30 for a small premium.

Perhaps it is time for the UK to go back to our old normal and end these gambles on future interest rates by people who just want to buy a home.

Not so much back to the future as forward to the past.

Paul Lewis presents ‘Money Box’ on BBC Radio 4, on air just after 12 noon on Saturdays, and has been a freelance financial journalist since 1987. Twitter: @paullewismoney