UK interest rates are the lowest they've been for three centuries! Many people think the Bank of England will keep rates low because of uncertainty around Brexit. We disagree. We think that U.S. rates may drag UK rates higher. To find out the reasons for this, and also to understand how monetary policy works, read on.

The Bank of England has a really nice explainer on monetary policy. Their job is to steer inflation toward a two percent target, and the primary mechanism by which they achieve that is to set interest rates.

The economy is a little bit like a party. If the party is growing a bit dull you spike the punch bowl. If the party is getting a bit too rowdy you take the punch bowl away. The monetary policy equivalent of Absolut Vodka is to lower interest rates. This lowers the cost of borrowing, it makes savings less attractive and borrowing more attractive and by lowering debt servicing costs it increases disposable income. There's also a Wealth Effect because lower rates tend to boost equity prices and house prices and when people feel richer that Wealth Effect makes them spend more. As a result output increases, employment increases, and the demand for employees grows more quickly than the supply of employees. That means wage bargaining favours employees, which can also lead to wage inflation.

If the MPC removes the punchbowl by raising rates everything goes in reverse: spending falls and inflation falls. The scenario we're in at the moment is on the right-hand side in red. We've had a very long period of very low rates and, yes, the lowest since 1694. The equivalent of the Monetary Policy Committee in the U.S. is the FOMC the Federal Open Market Committee and here you can see them in action.

On Valentine's Day Fed Chair Janet Yellen gave her semi-annual Monetary Policy Report to Congress. As usual she's spoke in "Central Bank Speak", or "Fed Speak" in this case, which is always very cagey. But I've highlighted one note of clarity. She says that if you take away the punch bowl too late that means you may have to raise rates rapidly and that could cause a disruption to financial markets and push the U.S. economy into recession and given the importance of the U.S. economy that would be a bad outcome for the whole World.

Interest rates in the U.S. have been close to zero since the Financial Crisis which is a period of about seven years. In December we started to see them rise. The effective rate is now about point three four percent.

The FOMC members each provides one dot on this chart for each date. This "dot plot" is their best guess at the policy rate in 2017, 2018, 2019, and in the longer run. Each time they raise rates they do it by a quarter of a percent so that would translate into three rate increases in 2017. That's a fairly speedy outlook for rate increases in the U.S.

Here in the UK growth hasn't been as strong as the U.S. so people think that we're less likely to increase rates in the UK for some period of time, and they call this policy divergence because the policy rate in the UK, but also in Europe and Japan, will remain low for some period of time lagging behind the US.

Why should we care about the US? We've got 2,000 miles of Atlantic separating us from the US. We've got our own currency, we have our own central bank, and we have our own Monetary Policy Committee which sets rates that are appropriate to our own economy.

Here they are looking resplendent in their suits at the Bank of England. And although the Bank of England projects that inflation is likely to increase because of the Sterling devaluation following Brexit they stressed that they'll remain cautious because of risks to the economy. So the outlook for rate increases in the UK is still fairly balanced.

What if we were linked to the US more closely than we expect? This is a 2012 research paper from the IMF. What they've done is to split growth into the cyclical bit that's the booms and busts on the left and the slow trending bit which is this stuff on the right. Now, what's remarkable is that the booms and the busts, the cyclical growth, is highly correlated both within Developed Markets but also between Emerging and Developed markets, whereas on the right you can see that the trend growth is extremely divergent. Developed Market growth has just been atrocious since the Global Financial Crisis. But if you strip out the booms and the busts, Emerging Markets are powering ahead!

The report says that the correlation in booms and busts is down to three factors. Firstly the share of trade in global economic activity has increased and that's why recessions in one country tend to spread out into others. And the same's true when one economy booms, it drags up the others, particularly a large country like the US.

Secondly financial markets are highly interlinked. Investment banks are global entities, and it's easy for a multinational to buy instruments in any country. That means that financial markets are highly interlinked, and if there's a problem in one country it spills over into others. The subprime mortgage crisis in the US is one example of that, and the Greek sovereign debt crisis is another.

A more intangible factor is "Animal Spirits". Markets aren't just rational: they have a mood. Sometimes that mood is positive, sometimes it's glum. And that's a really important driver of returns. Bull markets can be driven by positive sentiment and the Trump Rally since November the eighth is a great example of that. Trump has definitely rekindled animal spirits in the US and that spilled over into share markets globally.

However, this is nothing new. If you look at historic growth rates for the US, the UK and Germany you can see that when there's a recession in the US, which is at the top, the UK and Germany seldom get away without a recession of their own, or at least a slowdown, and if we look at policy rates in those three regions you can see that they too are highly correlated. If you look in detail you'll see that the Fed tends to lead the Bank of England and the ECB. In other words: where they go we follow.

So if the Fed does start to raise rates more quickly than people expect towards the end of this year I think it's very likely that the Bank of England and the ECB may not have a choice but to follow. But that may be for good reasons because growth may pick up in these two regions as a result of increasing growth in the United States.

However, there are some worrying things about the UK economy. The primary worry for me is household indebtedness. In the UK we're up to our eyeballs in mortgage debt. The measure used by the Bank of England is the household debt-to-income ratio. If the household income is 100 k and the household debt is a 100 k then that ratio would be a hundred percent. At the moment though we're not far below where we were before the Global Financial Crisis in 2007. The UK economy never really de-levered after the crisis. That means that if interest rates do increase it could be very expensive to service the debt that we hold, and that may be a significant drag on UK growth.

My second concern is that the very strong growth we saw at the end of 2016, which surprised the Bank of England, was partially thanks to a rise in consumer credit growth we went shopping but we did it on our credit card which means that if interest rates rise that activity will fall.

To summarize, we think that UK rates may be dragged up by US rates but because we're so highly indebted it's going hurt. Thanks to Brexit, not many people think that rates are going to rise quickly in the UK or in Europe. If we're right and that does happen then you should cut your exposure to long-term bonds, that's bonds with long duration because they're the ones which will sell off the most.

Are rising interest rates something that worries you? Perhaps you're a household which is heavily in debt, and you're struggling to pay the mortgage? And do you think the Bank of England will raise rates if they know that the UK is so heavily indebted? Tweet us your views @PensionCraft or message us on Facebook and, if you like what you see, subscribe to our videos