Everything you need to know about Interest Rates.

Executive summary:

This short article has been written to explain the idea of interest rates in a nutshell as well as clarify many common misinterpretations surrounding the base rate and the primary role of the Bank of England. Questions such as why the central bank use a base rate, how they actual change the rate, what the changes to this rate actually mean and how this can affect mortgage rates will be explored and answered so that next time you see a news headline or billboard discussing interest rates, you can understand it like an ‘undercover economist’. A few comparisons will also be drawn between the U.K. and other leading economies such as the USA, which is currently pursuing contractionary monetary policy by increasing the base rate to curb rising inflation and prevent the economy from ‘overheating’. On the flipside, Japan, which has suffered from persistent deflation over the last 20 years, has been experimenting with negative interest rates to try and ‘kickstart’ the economy and reverse the negative impacts of deflation.

The research referred to in this article is from well-established and trusted sources including the Financial Times, The Bank of England, The Guardian and the BBC. Figures used are up to date at the time of writing (August 2018). If you have any questions about the content discussed in this article please contact me at rajveersira@gmail.com.

 

Interest Rates:

An interest rate refers to the cost of borrowing money from a financial intermediary or the rate of return on savings. It is essentially where those who have extra cash can lend this to others who require this cash now in exchange for a financial reward. Banks facilitate this process, as people with excess cash do not directly lend to others, instead they deposit their money into an account where they receive a financial reward for holding it there. Banks use these deposits as loanable funds and the amount they charge to borrow is more than the amount they pay depositors allowing them to make a profit.

 

The Central Bank and The Government:

A central bank also known as a ‘reserve bank’ or ‘monetary authority’ is a financial institution, which enables a country’s economy to function. In the UK the central bank is the Bank of England (BoE) and in the US it is the Federal Reserve.

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The role of a central bank varies from country to country but in the UK the BoE is responsible for issuing banknotes, keeping an eye on the financial system to prevent systemic risk and most importantly setting interest rates at the right level. They hold other currencies to manipulate rates as well as gold reserves belonging to the UK. During the financial crisis they acted as the ‘lender of last resort’ to bail out banks such as Northern Rock and protect the economy from collapsing. Consequently their role is different to a conventional high street bank that aims to maximise profits.

Although the BoE is wholly owned by the UK government, the two parties are independent from each other. This means that they can maintain monetary and fiscal stability without a political mouthpiece. The current governor of the BoE is Mark Carney who heads up a committee of eight other members.

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Inflation and Interest Rates are inextricably linked:

The primary objective of the BoE is to meet the target of 2% (+/-1%) set by the government-often referred to as target 2.0. A committee known as the Monetary Policy Committee (MPC) meets eight times a year to agree on the rate at which the base rate is set to control inflation and provide stability within the economy. Of course political factors do enter the remit of such decisions, for example interest rates were cut by 0.25% following the 2016 referendum vote to prevent the economy entering a recession. Changes to the base rate filter through the transmission mechanism meaning that their effects can take up to 18-24 months. As a result the MPC tries to forward plan to overcome this; however, in many cases it speculation related.

 

Bank Rate, Base Rate, Mortgage Rate, Savings Rate……….?

Economists often like to use niche jargon to make something, which is actually quite simple, seem more complex. To clarify things, the bank rate is the rate at which the central bank in the country lends money to commercial banks and it is the rate of interest the BoE pays on reserves held by commercial banks at the Bank of England. For this reason, banks normally pass any changes in Bank Rate onto their customers. When the Bank Rate is raised, banks usually increase the interest customers have to pay on borrowing and the interest they earn on savings, and vice versa. Higher interest rates mean people will spend less in order to service their debts and benefit from good savings rates. This puts downward pressure on inflation. When interest rates are lower, the opposite is true. ‘Bank Rate’ is the single most important interest rate in the UK. It is set by the MPC, normally eight times a year and is often called the ‘Bank of England Base Rate’ or even just ‘the interest rate’.

 

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Why are loans not the same as the bank rate?

The number of different interest rates available when you borrow or save can be confusing.

That is because the interest rates that commercial banks set depend on more than just Bank Rate. For loans, these other factors include the risk that the loan will not be paid back. The greater the risk, the higher the rate the bank will charge.

 

What other tools do they have?

 There is no upper limit to the level of Bank Rate, but there is a level below which it cannot be reduced – this is known as the ‘effective lower bound’ or ‘zero lower bound’. The MPC currently judges this bound to be close to, but a little above, zero. This ‘zero-lower bound’ was experienced during the financial crisis whereby reducing interest rates further did not yield an increase in inflationary pressure. To help overcome this, they introduced unconventional monetary policy measures, namely Quantitative Easing (QE) which essentially involves creating money electronically (“Printing Money”), with the intention of stimulating the economy.

 

How do changes in this rate affect the economy and consumers?

The most recent change at the time of writing (Aug 2018) to the base rate is the increase from 0.5% to 0.75% – the second time that the base rate has been raised since the global financial crisis a decade ago. Four key Economic reasons why the MPC unanimously voted to raise the base rate include:

  1. Expectations of a strengthening economy- After the Beast from the East depressed consumer spending in the first part of the year, the Bank of England is now convinced that the British economy is regaining strength.
  2. Solid employment levels – the UK is estimated to be at the natural rate of unemployment of around 4.3% meaning there is a small positive output gap. If slack in the economy is dissipating, inflation may overshoot without a rate rise.
  3. More consumer spending – linked to rising confidence and real wage increases-Inflation 2.4% in June 2018.
  4. Argument that the Bank should raise rates now while the ‘going is good’, to give itself wriggle room when a recession hits in future.

 

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Generally, a rise in the Bank rate is good for the UK’s 45 million savers and bad for borrowers – but the reality is a bit more nuanced. Here are some of the main impacts of the most recent change according to the BBC:

  • Mortgages will become more expensive unless you have a fixed rate agreement. Across the UK, 9.1 million households have a mortgage. Of these, more than 3.5 million are on a standard variable rate or a tracker rate. These are the people who would be most affected, as their monthly payments would increase. The relatively small rise will not be particularly painful for the vast majority of householders, although debt charities say that some squeezed families will find this extra burden a real challenge.
  • The interest rate on fixed rate savings accounts, linked savings accounts, and cash ISAs should increase along with the new base rate – but it isn’t guaranteed, and the rate might not increase by the full 0.25%. (Savings rates didn’t increase by much the last time the base rate increased by 0.25%).
  • The APR on some credit cards is linked to the Bank of England base rate meaning a rise could follow.
  • Most personal loans are on a fixed interest rate, which means they’re unaffected by a base rate increase.
  • Any rate rise might also good for retirees buying an annuity – a financial product that provides an income for life.

 

 Clearly there are winners and losers with this outcome and as is the case in economics, there is no “one size fits all policy”; however, one can agree that this does seem like a logical decision which should help keep the economy on track. That said, with Brexit currently heading toward a ‘no deal’ outcome, the situation might deteriorate resulting in new measures having to be taken by the MPC. Although the UK is at a record low level of unemployment putting upward pressure on the price level, there are a significant proportion of underemployed workers primarily due to the expansion of the ‘Gig Economy’ and prevalence of zero hour contracts. This means that the actual level is masked, perhaps exacerbating the impact of a change to the base level, worsening final outcomes.

 

Further Reading:

If you enjoyed reading this article and are looking to expand your knowledge of economics by reading similar articles, check out: https://rsira-economics.com and make sure to subscribe if you haven’t already, where a wide variety of topical economic issues ranging from Brexit, a world without oil and common economic themes such as the invisible hand to more esoteric concepts such as Akerlof’s lemon theory, are discussed. As a starting point, you may wish to read the post on the causes of the 2007-8 financial crisis and some of the precautions banks are now required to take in light of this. Arguably one of the greatest financial meltdowns in recent times, it took many economists by surprise, yet by understanding what went wrong it can help us to analyse future situations and prevent the same happening again. Alternatively you may wish to read the post on quantitative easing to get a more in depth and technical understanding of how this works.

The Petrol Industry: Past, Present, Future

Background on oil

 Oil prices are volatile primarily due to the fact that they are determined by the market forces of supply and demand. These forces can be influence by a range of factors; for example conflict in Middle Eastern countries could result in political insatiability that may disrupt supply chains. Likewise economic sanctions may be placed on certain countries, which limit supply and put upward pressure on prices. On the flipside, oil prices may fall when governments are pressured to consider ‘cleaner and greener’ options or when new oil wells are discovered. Consequently when we fill up at the pump, the price per litre is rarely exactly the same as it was last time. Companies e.g. petrol station owners and even consumers must factor in this volatility to ensure that profit and utility are maximized.  Despite these short-term challenges, there are greater and perhaps more important issues to consider such as the options left for conventional refueling stations as the market changes to adapt to alternative energy in light of the 2040 UK ban on the combustion engine.

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The Petrol Industry:

The demand for petrol can be considered relatively inelastic in demand since alternative technology e.g. electric cars and the charging infrastructure that this requires is not up to scratch yet and such projects/investments still remain expensive.

Therefore in the short term, petrol stations are somewhat protected by the fact that there are few suitable substitutes. 99% of trucks on the road use diesel engines and there are estimated to be only 200,000 electric cars on the road by the end of this year. However, this does not mean that petrol stations are ‘protected’ or shielded in the long run. In fact in 2040, when the UK introduces a ban on diesel and petrol engines, fuel stations will need to rethink their strategy to prevent becoming obsolete. Many consumers are likely to make the switch to such technology before the due date as the government rolls out tax breaks and offers trade in values in exchange for their combustion engine.  Although this ban does not include hybrid vehicles the demand for conventional fuels will be extremely low and such stations will need to make an investment to cater for the new emerging ‘green’ market.

Moreover many brands e.g. Volvo are looking to move toward hybrid plug in vehicles by 2020 with highly efficient engines meaning fewer fill ups and thus lower revenues.

 

What can petrol stations do?

When even the boss of Shell says his next purchase will be an electric car, one could be forgiven for thinking the game is up for petrol stations.

The main stations in the UK include Shell, BP, and Esso together with supermarket providers and independent stations. In terms of ‘future proofing themselves’ shell seems to be ahead of the game. There are a variety of fronts that they have taken these being: Hydrogen, Electric and convenience services. Below are some examples of the ventures that have been undertaken/planned:

  • Shell is part of a joint venture with Daimler and others to commercialise hydrogen gas for powering hydrogen fuel cell vehicles, which are electric cars that have a range nearer that of conventional cars than battery-powered cars. The Berlin-based joint venture has eight sites and plans to have hydrogen-fuelling pumps at 400 locations across Germany by 2023.
  • There are areas where it’s clear that there is a growing demand for battery electric cars, particularly in California and parts of Holland, so they are working on developing supercharging technology.
  • Shell is running trials in China to generate all the energy needs of a site from solar panel canopies.
  • In today’s digitally connected on-demand economy, retailers must work harder than ever to attract customers. Almost every UK Shell station now has a Costa coffee concession and around 30 have a Waitrose store attached. There is a huge number of people coming to service stations who are not filling up their cars but instead are coming in to buy breakfast, to get a cup of coffee, to get their car washed. Their need for convenience retail is more frequent than their car’s need for fuel.”
  • Shell sold 60m cups of Costa coffee last year. In the UK there are some Shell-branded stations that are already making more money from selling products other than fuel. With that in mind, Shell is experimenting with different ways of luring customers to its stores and encouraging them to spend more time there. The company has two sites in Bangkok that sell only V-Power, Shell’s highest quality fuel, alongside a luxury cafe. Each customer gets two attendants – one to serve them and one to service their car.
  • Increasing the retail offering of service stations will become even more important as cars become more efficient, needing to refuel less frequently. This means that revenues from fuel will be on a downward path until the switch is made or revenues from non-fuel products take over.
  • Shell is preparing to open Britain’s first “no-petrol” service station in the capital next year as part of its drive towards cleaner motoring.
  • Later this year Shell plans to roll out high-speed electric vehicle charge points across a selection of its 400 UK service stations, allowing drivers to charge their electric vehicle batteries by up to 80pc in 30 minutes. The group is about to begin an 18-month pilot scheme to test what the forecourt of the future might look like. Service stations will be presented ambitiously as “retail destinations”, providing good quality food and coffee alongside high-speed Wi-Fi. The trial will also include collection points for online shopping deliveries to improve convenience and perhaps even the addition of a post office or pharmacy to “transform” into a retail hub rather than a traditional fuel station.

 

Potential problems:

  • Tesla, although a niche segment of the market has its own network of superchargers, meaning such customers may be reluctant to use other “inferior” charging stations. That said the network still remains small and these owners will inevitably have to use other stations.
  • Other manufactures may develop their own charging networks e.g. BMW/Audi reducing the need to visit a ‘transformed station’ but instead to use the manufacturer’s network. That said, it is unlikely every manufacturer will build a network, rather they are likely to collaborate to prevent a misallocation of resources and focus and expanding the network as much as possible.
  • Independent stations may struggle to invest and stay ahead of the game especially if they are slowly experiencing a fall in their revenues and cannot afford to make adequate investments.
  • In the short term, the government may look to introduce a more hefty ‘carbon tax’, squeezing consumers further and perhaps forcing them to consider moving towards renewable options. This could drastically reduce profits for petrol stations owners from fuel sales.
  • Apple, the first company to hit $1trn could launch the iCar within the next 5 years. Apple has a trend for disrupting the market e.g. the death of blackberry, and some rumors suggest that this car may be entirely powered by solar power eliminating the need for on route charging stations.

 

Verdict

Overall it is clear that in the short term, conventional petrol stations are not going anywhere soon, in fact there have been a number of setbacks with alternative energy, together with the technical & ethical issues of driverless cars meaning that such a transformation to a new automotive market could take time. However with the 2040 ban in the pipeline, the clock is ticking and as we’ve seen in the past with the revolution of smartphones and social media, once technology takes off, there’s no looking back and only those that have read the market correctly will be left standing. The impact of this is not solely on petrol station owners but on the government.  The Treasury stands to lose up to £20billion of fuel duty and VAT every year if retail sales of petrol and diesel evaporate meaning that it has less to ring-fence and put toward grants to help embrace this change.

Potential questions:

  1. The Government is boosting its push to promote electric and driverless cars with a draft law requiring petrol stations across the country to install more charging points. Have do independent petrol stations plan to insulate themselves from the expected future changes to the market such as the roll out of electric cars following the 2040 ban on conventional combustion engines?
  2. How will they compete with the big players within the industry who have access to large amounts of capital to invest and embrace this new change? (Shell invests £1billion a year on renewable energy)
  3. Supermarkets now dominate the petrol-selling market – Tesco alone sells 15%. They often undercut their rivals on pump prices and sometimes run at a loss with the sole aim of attracting customers to their stores. If customers make a move towards electric vehicles it is likely Tesco and others will make large scale investments to ensure their customer’s can ‘shop and charge’. How will independent stations compete with this competition? Would they consider merging with other services e.g. post office/pharmacies?
  4. Finally, the Number of petrol stations has fallen from 14,000 in 2000 to 8,500 today. If new charging points become ubiquitous e.g. in every office, car park, supermarket, the future for such stations could look even more bleak. What could they do to ensure their profits remain in tact?