The nominal interest rate – that focused on by the majority of commentators – is of less importance than the real interest rate (the nominal rate minus inflation rate), according to Richard Woolnough, manager of the M&G Optimal Income Fund. He explains, ‘If nominal rates rise from five per cent to six per cent, but inflation jumps from two per cent to four per cent, then real interest rates have actually fallen. Consumers will react by borrowing more, not less, as they seek to spend money now to avoid the eroding effects of inflation.’

Woolnough said that real interest rates had remained at about two per cent from 2003 to 2006, despite a steady increase in nominal rates from 3.5 per cent in 2003. ‘In reality, monetary policy at the beginning of this year was just as expansionary as in 2003, but four years ago the Bank of England was trying to avert recession and was worried about deflation.’

Rate rises from the Bank of England were needed this year and were no surprise, he added. But despite a 0.25 per cent increase in nominal rates since May, Woolnough said that a drop in inflation meant that real interest rates have climbed by one per cent during this time.

‘If you measure real interest rates using three-month LIBOR – which is the rate at which banks lend to each other and is therefore the rate that matters most to the man on the street – then real interest rates have jumped by 1.2 per cent,’ he added.

Any increases will reduce consumer borrowing, cut corporate investment, slow the housing market and slow the economy, according to Woolnough. He continued, ‘There is currently no need for the Bank of England to raise interest rates, and the next movement is likely to be downwards. The timing depends on how quickly and to what extent US economic woes affect the UK, and how the UK housing market pans out.’