Please Note: This Article is 6 years old. This increases the likelihood that some or all of it's content is now outdated.

2015’s ‘inevitable’ base rate increase looked a lot less inevitable last week when Ian McCafferty and Martin Weale, the two hawks of the Monetary Policy Committee, fell back in line and voted for interest rates to remain level.

The vote was unanimous for the first time since August last year, when McCafferty and Weale first broke ranks by calling for a moderate rise of 0.25 percentage points.

The backpedalling was likely in response to economic performance at the end of 2014. Inflation in December was just 0.5%, the lowest level in nearly 15 years, and well short of the Bank of England’s 2% target.

Economists are now predicting that low inflation will prevail over the coming months. The Bank of England, meanwhile, hinted that the UK might even experience deflation – the same problem that is currently plaguing the Eurozone.

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What does this mean for the mortgage market?

Low inflation is good news for households in the short term, as it means that goods are cheaper. This in turn promotes spending and investment and helps to boost the economy.

Low inflation also encourages monetary policymakers to act to encourage spending, which they do by reducing interest rates. In a low interest rate environment, savers are punished and spenders are rewarded.

Deflation, on the other hand, is more difficult to manage. There is a greater precedent for interest rates to be negative in real terms (i.e. below the rate of inflation) than in nominal terms (i.e. below zero). Last June, however, the European Central Bank (ECB) did in fact introduce a negative deposit rate. This means that commercial banks have to pay to hold money with the central bank.

Cutting the Bank of England base rate to below its current all-time low of 0.5% could prove fatal to smaller banks and building societies. To get around this, the central bank has itself entertained the notion of introducing a negative reserve rate. Levied only on excess money placed with the Bank of England by commercial banks, this would theoretically stimulate lending to businesses and consumers.

If the Bank of England were to once again consider this measure, it could mean mortgage interest rates falling even further.

This is not a given, however. Tracker rates, for one, would not be affected, as they are tied to the Bank of England base rate. Many variable rates, meanwhile, are ‘collared’, meaning they cannot fall below a certain level.

The cost of debt

While a deflationary environment may or may not have a discernible effect on borrowing costs, it will have a definite effect on the size of debt.

Many buy-to-let investors prefer interest-only mortgages for a number of reasons, one of which is that inflation will reduce the size of the debt in real terms over time. Deflation will have the opposite effect, making a static debt worth more. A long period of deflation, then, could drastically increase the burden of a buy-to-let mortgage and render one of the most popular investment strategies significantly less viable.

We should put such concerns in perspective, however. Brief periods of negative inflation, such as those experienced in 1959 and 1960, and more recently in 2009, are not considered periods of deflation in an economic sense, and are not always a cause for economic concern. For a buy-to-let investment, which tends to be medium- to long-term, they should cause little trouble.

Through its knock-on effects, long-term deflation can be disastrous for an economy, with declining profits resulting in reduced production, lowered wages and rising unemployment. But the last time the UK experienced prolonged deflation such as this was in the 1920s and 1930s, and any periods of negative inflation since then have been transitory. For its part, the Bank of England expects inflation to be back at 2% by 2017, meaning that a typical buy-to-let investment should withstand any short-term deflation the UK experiences.

If you are concerned about the impact of deflation on your overall debt, be sure to discuss alternative investment strategies (such as repayment, part-repayment or flexible overpayment mortgages) with your buy-to-let advisor.

Written by Ben Gosling for commercialtrust.co.uk

Please Note: This Article is 6 years old. This increases the likelihood that some or all of it's content is now outdated.
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