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Brexit and interest rates

25th Jun, 2016

By Robert Little

In the wake of the EU referendum you might have heard that UK interest rates could either rise or fall. In this post I will explain the link between Brexit and interest rates and weigh up which is more or less likely.

Why might interest rates fall?

Interest rates are used by central banks to steer the economy. In the UK the Bank of England’s Monetary Policy Committee sets the “base rate” or interest rate and this has been unchanged at 0.5% for over 8 years.

If the Bank of England wants to improve the economy or increase inflation it will cut interest rates (there are benefits of a higher inflation rate which are beyond the scope of this post). A lower interest rate encourages businesses to borrow and invest in their companies, it encourages people to spend more rather than saving more and it reduces spending on debts (like mortgages) so households have more income available to spend in the economy. This should increase economic growth, increase inflation and reduce unemployment.

Some economists believe we could see one or two interest rate cuts in the coming months, possibly from 0.5% down to 0.25% or 0%. This is likely to happen if the UK economy starts to shrink or if uncertainty about our country’s future increases. A key concern is companies could move away from the UK and other companies will not invest in the UK, both of which could result in lost jobs and a general lack of confidence which could then have a knock-on effect on economic growth.

An interest rate cut is fast and effective. Importantly it is a decision which does not depend on the government, so fighting within the Conservative and Labour parties will not slow or stop an interest rate cut.

Why might interest rates rise?

An interest rate rise in the event of a Brexit vote was predicted by one of the members of the Monetary Policy Committee in May this year. The key reason for this is the fall in value of sterling. On results day the value of the pound fell dramatically and was trading at a 31 year low against the US dollar (as well as other currencies). This is unfortunate for two reasons: first around 50% of the food we consume is imported from overseas (and around half of this imported from the EU); second oil is priced in dollars and we import a lot of oil.

When sterling weakens it means the goods and services we mostly buy from abroad (e.g. fuel) cost a lot more in pounds and pence. Inflation is simply a measure of how much a “basket” of goods costs, so if this “basket” costs more due to an increased cost of imports then we will experience higher inflation.

As I explained above the Bank of England could cut interest rates if it feels inflation is too low, so if it feels inflation is too high we may see a rate rise. This would slow the economy and it should increase the value of the pound, which could combine to result in a fall in inflation.

Which is more likely?

Given the period of uncertainty we are entering it appears most likely there could be a rate cut or no change in rates. A rate rise could be used if we experience a fairly significant and persistent jump in inflation. However the Bank of England’s inflation target is 2% per year and it is currently hovering just above 0%, so in theory there is plenty of room for future inflation increases without the need for an immediate rate rise. Those with debts will prefer a rate cut but of course this comes at the expense of penalising savers even more.

In reality the Bank of England will have to juggle a combination of lower economic growth, less confidence and a rise in inflation so there will not be a one size fits all interest rate decision. For now for the Bank of England the only certainty is uncertainty.

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