Hello readers, welcome back to my blog.
I hope you enjoyed reading my post last time about the financial crisis and now have a clearer understanding of why it actually happened. This week I thought I would take a look at the recent rise in the base rate of interest, by the Bank of England on the 2nd of November from 0.25% to 0.50%. As I discussed in my last post, interest rates have been at ‘ultra low’ levels since the financial crisis and only now are they starting to rise. The Bank of England is expecting two further rises by the turn of the decade which would leave them at 1%-still considerably lower than pre-crisis rates, thus indicating that Brexit related uncertainty and low overall ‘animal spirits’ in the economy are limiting the UK’s growth potential. However, Mark Carney has said that “any further increases in interest rates would be at a gradual pace and to a limited extent”. Despite the fact that high street sales are falling at their fastest level since the height of the recession in 2009 as consumers “tighten their belts”, and even though the UK is facing high levels of consumer debt, coupled with mounting uncertainty and sluggish growth, Threaneedle Street has indeed taken the decision to reverse the emergency action taken immediately after the Brexit vote, voting 7 to 2 for a raise. Within this post I will explain why we have seen a rise, the impacts of this rise as well as evaluate whether monetary policy has been effective over the last few years.
Why have they risen?
For over 30 years control of inflation has been the main objective of U.K. monetary policy; in order to create conditions in which the ultimate policy objective of improved economic welfare can be attained. Changes to the Bank rate is referred to as conventional monetary policy; however, in come cases central banks have to resort to unconventional monetary policy measures such as Quantitate Easing (QE) as interest rates are at the ‘zero lower bound’ i.e. the bank has ‘run out or road’ and cutting interest rates will no longer control the economy.
The Bank of England has a target of 2.0% for CPI inflation and currently the level is at 3.0%, expected to rise to 3.2% next month. The rise in inflation is linked to the weaker pound which has meant that UK exports become cheaper in foreign currency terms and imports to the UK become more expensive in domestic currency terms. Although cheaper imports are likely to lead to an increase in demand for them, this is not always the case. For example, the ‘Martial Learner Condition’ suggests that the effectiveness of a depreciation depends on price elasticities of demand for exports and imports. It states that “For a fall in the exchange rate to improve the trade position, the combined elasticities of demand for exports and imports must be greater than 1. If combined elasticities are less than one, a fall in the exchange rate will worsen the defect”.
We could also look at the ‘J curve’ effect which states that in the short run, quantity demanded of exports and imports may be inelastic due to short term contracts and the ‘wait and see policy’ where by firms/consumers hold back spending to see what is likely to happen next in the economy. Thus if we consider the flipside-for a depreciation to be successful, firms in the domestic economy must have spare capacity to meet the surge in demand for exports. Also, the effect of a depreciation may be short lived as competitiveness may be eroded by cost push inflation. Hence, trade balances may actually worsen in the short term following a depreciation of the exchange rate. Moreover, the UK has a marginal propensity to import; that is, we as a nation are likely to spend more on imports as our disposable income rises.
Last month’s inflation was also thought to have risen since the cost of fuel and raw materials for industry was up by 8.4% a year ago, although clothes had come down in price. Consequently prices in the UK are rising at a faster rate than anywhere in the G7 group of leading global economies, according to the Organisation for Economic Co-operation and Development (OECD). The UK is only behind Turkey, Mexico and the eastern European states of Latvia and Estonia in the club of 35 developed nations. The rise in prices was also above the averages for the euro area, the wider European Union and the G20 nations.
The graph below from the BBC illustrates how the base rate of interest has changed since the millennium.
What does the rate rise mean for you and has monetary policy been effective?
For those of you who don’t know, Monetary Policy is part of the economic policy that attempts to achieve the Government’s macroeconomic objectives such as low and stable inflation using monetary instruments, such as controls over bank lending and the rate of interest. Quantitative easing an unconventional measure essentially involves new money being created electronically to buy financial assets such as government bonds, on the country’s financial markets, which influences a commercial banks’ ability to lend money. This can stimulate consumer spending (approx. 65% of Aggregate Demand), as well as investment spending, thus boosting AD and economic growth. The effectiveness of monetary policy however is questionable and certain policies have been carried out with varying degrees of success. For example changes to the base rate feed through the ‘Monetary Policy Transmission Mechanism’ meaning that there is an 18-24 month time lag before we see the full effects of a change to interest rates. Similarly with QE, many economists argue that this £375bn asset purchasing scheme did not drastically raise demand after the great recession since banks were reluctant to lend. Some economists argue that it would have been better to give people the money to spend rather than to the banks and that the money should have gone into the real economy e.g. via tax cuts. That being said, we cannot test the counter-factual; what would have happened without QE and we do not know where the economy may have been without these emergency measures. In addition monetary policy may have been unsuccessful in 2010 since it was not in line with other macro-economic policies such as fiscal policy. During this time the coalition party, enforced austerity (higher taxes and less government spending) thus contracting the economy and the aims of expansionary monetary policy. Therefore we can say that although the economic theory may suggest what is likely to happen, the actual success of certain policies depends on a range of factors that economists cannot predict.
In Economics, there is never a “one size fits all” policy and inevitably there will be winners and losers in these situations. The winners will include 45 million savers, who are likely to see higher returns from savings accounts. A number of providers have already announced they will be increasing savings rates in line with the rise. Mark Carney, the Bank’s governor, said he expected other providers to follow suit. Those planning on buying an annuity to finance their retirement will also benefit. But for at least four million households with variable rate mortgages, monthly payments are set to rise immediately. Across the UK, 9.2 million households have a mortgage. Of these, around half are on a standard variable rate or a tracker rate, amounting to between four and five million households. These are the people who will be most affected, as their monthly payments will increase.
The average easy-access savings account is currently paying 0.14% in annual interest, according to the Bank of England. So someone with £10,000 worth of savings is earning £14 a year. If the rate rise is fully passed on, they would earn an extra £25 a year, making £39 in total. A saver with £10,000 in a typical cash Individual Savings Account (ISA) would see their income rise from £30 a year to £55.
Households, in total, are expected to face about £1.8bn in additional interest payments on variable mortgages in the first year alone. It is also estimated that households will pay as much as £465m in additional costs on credit cards, overdrafts, personal loans and car repayments.
Many argue that this is the last thing that hard pressured families need. With UK living standards falling, the economy needs boosting not reining in. Furthermore, many poorer households are using credit cards to finance their day to day spending suggesting that they are already struggling. With real wage growth still being negative, and rising household debt which ultra low rates have encouraged over the years, such a rise is likely to be regressive i.e the poorest and most vulnerable in society will be hardest hit. The prevalence of low interest rates has promoted a culture whereby such low levels of interest are the norm. While consumers may have got used to these levels, it is estimated that 8 million Brits have not seen a rise in their adult life.
The rise in interest rates is also likely to improve the exchange rate and help the weak pound to recover amidst the Brexit related uncertainty. This is because raising interest rates makes Sterling more attractive to foreign investors leading to a flow of money into the UK referred to as ‘hot money’.
Carney’s main justification was that adding higher interest rates in small incremental steps, were part of ensuring that the real income squeeze ends and does not come back i.e. reducing inflation back to ‘sustainable’ levels and helping the economy to rebound from what some call “the permanent damage to the economy” after the financial crisis, deep recession and the credit crunch.
Others argue that interest rates need to rise because if the UK does face any more external shocks, as interest rates are at the zero lower bound, there is little room left for any adjustment to control the economy.
The graph below shows how interest rates have changed over the last few decades in the UK: