State benefits and pensions are set to rise by 5% next year, following the news that the annualised rate of inflation over the year to September was exactly 5%.
The Retail Prices Index (RPI) annual increase in September was 5%, up from 4.8% in August, thanks mainly to higher domestic energy prices. And for the first time for years, the Consumer Prices Index (CPI), the harmonised European measure of inflation, showed an even higher year-on-year rise of 5.2%. This is because the CPI does not include housing costs, but falling house prices are (indirectly) reflected in the RPI.
September’s annualised RPI increase is the basis for the following year’s state benefit rises, so the OAP and other benefits should all rise by 5% in 2009, unless the government decides otherwise - we will know when it publishes its Pre-Budget Statement in November. But it would be such a bad move politically to give a smaller increase that the 5% rise is almost sure to go through.
Inflation to fall in next two years
As for the inflation outlook, most economists agree with the Bank of England that it will fall back to the 2% target over the next 18-24 months. And some are far more optimistic, talking about CPI inflation at under 3% by next autumn. To a large extent, this is because of a stabilisation of energy prices and an expected drop in food prices following a sizeable fall in the price of wheat and other crops.
Meanwhile, the credit crunch has already prompted a 0.5% cut in the Bank of England’s base rate from 5% to 4.5%, and most economists expect another cut by the New Year. Some are predicting that the base rate will be as low as 3% by next summer.
While this will reduce the cost of borrowing including mortgages, it probably won’t reduce it in proportion. The banks, it turns out from the details of the government rescue package, will have to pay a rate for the government’s guarantee of their borrowing in the money markets that will result in them paying about 1% more than before the credit crunch started. Upward pressure on personal loan and other unsecured borrowing rates will therefore continue, so don’t expect any cuts here.
Falling swap rates
The good news is that the fall in base rate and 2-year swap rates means that fixed rate mortgage costs are, as I predicted a couple of weeks ago, likely to drop sharply by next January. And the banks have all signed up to continuing to provide mortgage lending to households at similar levels to 2007.
They have not committed to lending on similar terms, and we can expect average lending margins - the gap between what banks pay and what they charge – to settle at their pre-boom levels of 1.25% - 1.5%. The ‘going rate’ for a variable rate mortgage, with base rate at 4.5% and interbank lending at 5.5%, is therefore about 6.25% - 6.75%.
The bank rescue package will take time to work its way through the system, which means that interbank lending rates will only fall gradually, so we’re unlikely to see significant cuts in lenders’ SVRs until the New Year.
But at least, as far as both inflation and mortgage interest rates are concerned, the outlook is now far more positive than it was a few months ago.
