At its May meeting, the Bank of England voted (7-2) to maintain it’s base interest rate at 0.5%. This was in spite of earlier indications it would raise rates by 0.25%. In this post I set out the reasons why the Bank of England has backtracked and the implications for financial markets.
If you are concerned about the possibility of a future rise in interest rates and the impact this could have on your mortgage, please contact us and arrange a free mortgage review meeting with our qualified mortgage adviser.
Why is the Base Rate important?
The Bank of England controls the supply of all money in the UK, so if you have ever borrowed money from a bank it was borrowed from the Bank of England first. The Base Rate is the rate at which banks can borrow money from the Bank of England before they lend it to individuals and companies.
In other words, if you take out a personal loan at an interest rate of 4%, this money ultimately cost your lender around 0.5% and so they only keep 3.5% of it.
Rises in the Base Rate cause the cost of borrowing (and the benefit of saving) to increase. If loan payments (including mortgages, personal loans, credit card etc) increase it means people have less money to spend and this reduction in spending should have a dampening effect on the economy.
Even if you aren’t a borrower you would still have been affected by a change in interest rates. This is down to the wide-ranging effect a change in borrowing costs can have on the economy and on financial assets and company profitability.
Why did the Bank of England consider raising rates?
The Bank of England’s Monetary Policy Committee (MPC) has one goal: to keep inflation (the rising cost of living) at 2% per year. To do this they have various tools at their disposal, the most common (and effective) being a change to the Base Rate. If the MPC wants the economy to grow it will increase the Base Rate and if it wants the economy to cool down it will raise rates.
You might wonder why the MPC does not want an inflation rate of 0% (or less than 0%) so there would never be a rise in the cost of living. The reasons behind this are complex and far beyond the scope of this post but they can be summarised by considering what would happen if we did experience inflation of 0%. In this scenario there would be no incentive to buy anything today because it will cost the same in one year’s time and in 10 year’s time. If inflation is below 0% there is an incentive to delay spending because we know it will cost less in the future. This would cause purchases to be delayed and the economy would stagnate. If instead inflation is above 0% there is some urgency when making spending decisions, which keeps the economy ticking over. Too much inflation is a bad thing because there is a risk that wage rises won’t keep up with the rising cost of living. The target rate of 2% is considered a happy balance between too much inflation and too little.
Having a Base Rate of 0.5% for a prolonged period is not something the Bank of England wants. This is because if we experience a slowdown in the economy the MPC does not have the scope to cut rates significantly (a Base Rate of less than 0% is technically possible it would introduce a huge number of complications). The MPC wants to hike rates sooner rather than later so it has room to manoeuvre in the event of slowing or falling economic growth. However if it puts rates up too quickly this could cause a slowdown, which is why the MPC needs to tread carefully.
After the Brexit vote in 2016 the cost of living rose quite sharply and remained at around 3% for over 12 months. This was primarily caused by the fact the UK is a net importer of a lot of goods (including petrol and food) and the cost of these goods rose when the value of the pound fell.
An inflation rate of 3% (which is above the target rate of 2%) forced the MPC to consider a hike in interest rates. This should have caused the value of the pound to rise because a higher interest rate would make the UK a better place for international savers which would drive up the pound relative to other currencies.
Instead, in a move which surprised a lot of commentators, the MPC cut interest rates by 0.25%. It did this because it felt there was too much uncertainty surrounding Brexit and it did not want this to have an impact on confidence in the UK. You can read more about this on an earlier post here: Interest rate cut to 0.25%
This decision was reversed shortly afterwards and the Base Rate went back to 0.5%. Then, over the course of the first few months of 2018, the UK experienced a string of positive economic data, including better unemployment figures, which supported a hike in rates to 0.75%. The MPC released various statements indicating it would hike rates in May and financial markets felt a rate rise was almost a certainty.
Why did the Bank of England cancel the planned rate rise?
In the weeks preceding the MPC’s meeting more economic data was released which painted a less-rosy picture than indicated by previous data. This included a slowdown in a manufacturing index which is considered a key indicator of the health of the economy. There was also a fall in the rate of inflation to below 3%, which took the MPC closer to its target of 2%.
The MPC has taken this data into account and has delayed the planned interest rate hike until it feels the economy can handle this better. The Bank of England’s chief, Mark Carney, indicated after the vote that uncertainties caused by Brexit have also been taken into account in the MPC’s vote.
Carney is likely to face some criticism after the MPC’s decision because he has repeatedly talked up the possibility of a rate rise only to back down just before the MPC’s vote. However, the vote was 7-2 in favour of keeping the Base Rate unchanged at 0.5%, so Carney should not shoulder all of this criticism alone.
What impact has this had on financial markets?
The biggest impact has been in currency markets, where the value of the pound has slipped relative to most major currencies (including the US dollar and the euro). This is because a higher interest rate would have increased the return on some sterling-denominated assets, which would have made the pound more popular relative to other currencies.
The FTSE 100 (an index representing the share prices of the largest 100 companies in the UK) has also risen slightly, which could be partly to do with the fact a weaker pound makes the sterling-denominated profits of these large multinational companies more attractive.
Finally the cost of UK government borrowing, as represented by the interest rate available on gilts, has fallen slightly. This was to be expected given the fact UK government borrowing is heavily linked to the UK Base Rate.