On 1st November 2017 the monetary policy committee (MPC) of the Bank of England, Britain’s central bank, voted to raise interest rates for the first time since 2007. The committee reached an agreement to raise the official bank rate from 0.25% to 0.5% with a 7-2 vote in favour of the rate adjustment. In the announcement of the change, on Thursday, the bank also said that a gentle increase in rates over the next few years will be required to lower inflation to the 2% target and maintain price stability.
a gentle increase in rates over the next few years will be required to lower inflation to the 2% target
What has happened recently to interest rates and what is the reason for the rate increase now?
After the financial crisis and during the following recession the British official bank rate tumbled from 5% in September 2008 when Lehman Brothers collapsed, to a historically low level of 0.5%. Between 2009 and August 2016 rates were unchanged at 0.5%, but in the wake of Brexit the MPC voted to lower rates to 0.25% in August of last year, by far the lowest Britain has ever seen. Since then inflation has picked up and was measured at 3.0% during September[1], above the Bank of England’s target inflation rate of 2%. This can be seen as the main motivation for the bank’s interest rate rise.
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The recent rise in inflation can be linked back predominantly to the decline of sterling after the result of the referendum on Britain remaining part of the European Union. Since the pound has depreciated against the currencies of our major trading partners this has led to a rise in import costs, pushing up the general price level of goods in the UK. A recent increase in energy prices has also contributed to higher inflation as these higher prices are passed on to consumers.
Brexit has also led to increased uncertainty around the UK and thus to lower investment as well as slower economic growth, all of which the MPC has had to take into account in making this rate change and determining the Bank of England’s monetary policy strategy for the near future. Due to the large variability of potential Brexit outcomes the MPC’s recent outlook has been relatively conservative, and even after the unveiling of this new plan the attitude of the MPC seems to remain this way. Although a rise in interest rates is something that hasn’t been seen for many years, the Bank of England’s plan of gradually raising rates to 1% over the next three years is not an abrupt change in monetary policy stance or an unexpected move.
Due to the large variability of potential Brexit outcomes the MPC’s recent outlook has been relatively conservative
What has been the response of financial markets to the change?
Basic economic theory predicts that when British interest rates rise, the pound will appreciate, as foreigners buy up currency for saving at the new higher rate. However in the few days since the announcement, sterling has unexpectedly fallen. On Thursday, the value of the British pound dropped by 1.4% against the dollar and also fell by 1.7% against the euro but recovered against the euro slightly on Friday. The Bank of England’s communication of their intent has been blamed for this, as the bank has not managed to persuade markets that it is serious about future rate increases. On Friday, Ben Broadbent, the deputy governor of the bank sought to hammer home this message and convince the markets that there will be more rate rises in the near future, but there was little reaction in the pound’s value.
in the few days since the announcement, sterling has unexpectedly fallen
After the rate rise was announced on Thursday the FTSE 100 closed up 0.9% at 7,555, this is mostly due to the depreciation of sterling raising profits of British multinational firms, as many firms that make up the FTSE 100 receive revenues in foreign currencies which can be translated into a larger number of pounds now.
What will be the effects on ordinary people of the rise in the official bank rate?
The basic effects of a rate increase are an increase in returns to savers and an increase in costs for borrowers. The BoE expects retail banks will pass on the rate increase to savers but not immediately. Many borrowers will not be too badly affected by the rise, as 60% of mortgages are now at fixed interest rates so the cost of borrowing will not affect people with fixed rate mortgages for a while, moreover the Bank of England expects that many households will still be able to refinance their mortgages to a lower level in spite of the 0.25% rise in interest rates. Those with variable rates will soon see a rise in their repayments however.
The basic effects of a rate increase are an increase in returns to savers and an increase in costs for borrowers
Borrowing costs will no doubt rise for businesses, but the effects will be felt more so for smaller businesses compared to their larger counterparts, since they have less alternative options available to raise funds. They thus rely more heavily on borrowing, so an interest rate rise will affect them to a higher degree.
University students may rejoice on the other hand, as a policy to reduce inflation will be welcome news to those who have taken out loans with the Student Loans Company. Repayments are set at a level pegged to the retail price index (RPI)[2] and therefore if the bank rate rise and the MPC’s near-term policies lead to lower inflation, everything else equal, this will reduce repayment costs for university students and recent graduates.
a policy to reduce inflation will be welcome news to those who have taken out loans with the Student Loans Company
Overall the rate increase is fairly conservative and will affect everybody in different ways, some people may benefit while others may lose. However the rise in the bank rate is no enormous change, merely a quarter of a percent, so it should not be anything to get alarmed about. The Bank of England does however needs to be more convincing in its communications to the general public about its future intentions and implementation of policies.
[1] Measured using the consumer price index (CPI)
[2] The retail price index (RPI) – which is similar to the consumer price index that the Bank of England measures inflation by except it also includes different factors such as housing costs and excludes others such as stockbroker fees.
