Interest rate cut to 0.25%

4th Aug, 2016

By Robert Little

Earlier today the Governor of the Bank of England and Chairman of the Monetary Policy Committe, Mark Carney, announced a number of changes including a reduction in the headline interest rate. The cut from 0.5% to 0.25% is the first since the global financial crisis of 2009. In this post I set out the key changes announced today and answer some common questions.

What changes were announced?

1. A cut in the Bank of England Base rate, the headline UK interest rate, from 0.5% to 0.25%
2. An expansion of Quantitative Easing (or “QE”). This includes extra government bond purchases of £60 billion and corporate bond purchases of £10 billion. This will take the size of the existing Quantitative Easing program from £375 billion to £435 billion (the £10 billion corporate bond purchases will be done under a separate program to the government bond purchases).

What is Quantitative Easing (QE)?

QE has a similar effect to a rate cut as it is ultimately designed to encourage more borrowing, more investment, more spending and less saving. However QE works under a very different mechanism compared with a rate cut. The Bank of England has announced today it will increase its existing QE program to £435 billion by purchasing another £60 billion of government bonds. This means it will “create” another £60 billion (this involves computers rather than actual printed money) and it will buy government bonds off the private sector (typically the bonds will be purchased from insurance companies, banks and pension schemes). The idea is that after these purchases the private sector has sold an asset which generates some return (the government bonds) in exchange for cash which generates very little return. The Bank of England then crosses its fingers and hopes these sellers will put this cash to good use. For banks it is hoped they will loan the money out to individuals and businesses in order to earn a return in the form of interest. This should boost the economy because employment and spending should increase. For pension schemes and insurance companies it is hoped they will invest in other assets such as corporate bonds and shares. This extra demand for these assets should, in theory, drive down long-term returns and this should encourage companies to source new capital by issuing more shares or more corporate bonds. In theory this should raise extra cash for businesses which can then be used to invest in new projects, machinery, staff and so on.

What is a corporate bond?

A bond is essentially a loan. A company could offer, say, £10 million of corporate bonds with an end date of August 2021 and an interest rate of 2%. Investors can submit bids to buy these bonds and they may end up paying more than, less than or exactly £10 million. Let’s say the investors agree to pay £10 million. The company will receive this sum of money from the investors today and in exchange the investors will receive 2% interest each year for the next 5 years and, at the end of the bond term in 2021, they will receive £10 million. In the meantime the company has (hopefully) used the £10 million they received up-front to invest in a project which has earned a higher return than 2% per year. Earlier this week Microsoft issued $19.75 billion of corporate bonds, which was the third-largest issue in the USA. A government bond works on exactly the same principles as a corporate bond except the issuer is a government (such as the UK government) rather than an individual company. One of the key risks with corporate bonds is the company could run into difficulties and become unable to repay the interest or the final sum of money. This risk is negligible with a UK government bond because the UK government is not expected to default on its debt repayments.

Why is the Bank of England buying corporate bonds?

To date the Bank of England’s Quantitative Easing program has only purchased government bonds, so the promise to purchase £10 billion of high-quality corporate bonds over the next 18 months is new for the UK. However central banks in other areas (such as the European Union and Japan) have already expanded their QE programs to include corporate bond purchases as well as government bonds. Essentially the reason for this change is the return on government bonds is already so low that buying even more might have a somewhat muted effect. The Bank hopes that purchasing non-government bonds will cause QE to have a stronger impact than purchasing even more government bonds.

Will my bank cut savings rates?

It seems likely that banks and building societies will take this opportunity to cut savings rates but individual providers will react differently. Mark Carney said the Monetary Policy Committee recognise this is an unwanted side effect of a rate cut but they believe the cut is necessary anyway.

Will my mortgage rate change?

If you are on a tracker rate it is likely you will see a cut in your mortgage interest rate, unless your mortgage product has some sort of minimum rate built in (which is often called a “collar”). If you are currently on a fixed rate your mortgage payment shouldn’t change but, if you are considering taking out a new mortgage with a fixed rate, it is possible (though certainly not guaranteed) fixed rates could reduce given the announcements today. Finally if you are on your lender’s Standard Variable Rate (SVR) then you may or may not get a cut in your mortgage rate. Lenders are not compelled to reduce their SVR in the event of a cut in the base rate and, given the fact they are already at an all-time low, it is quite possible they won’t be willing to cut them further. Mark Carney has acknowledged this but said there is no reason SVRs shouldn’t be reduced – although he has no power to enforce this with individual lenders.

Are there more changes to come?

It appears likely that we could see more of the same at next month’s Monetary Policy Committee. Mark Carney said today that while he would never cut interest rates to below 0% (which the European Union and Japan have already done) he would like to see interest rates only slightly above zero. We could also see a promise to purchase more government bonds and/or corporate bonds.

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