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.

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