The UK government and the Bank of England have used the UK base rate as a relatively crude monetary tool for many years. While this is just part of the country’s monetary policy armoury, it is incredibly effective, and changes to it can have an immediate impact.

Managing consumer spending

How the Bank of England uses the UK base rate to control the economy is simple. If the economy is overheating, the Bank of England will raise base rates, making borrowing more expensive. This reduces the availability and affordability of debt, lowering consumer spending. If the economy is struggling, as we see today, the Bank of England will reduce the UK base rate. This makes borrowing cheaper, therefore encouraging consumer spending using relatively inexpensive debt. The economy recovers, interest rates return to “normal levels,” and a degree of normality resumes.

Combating inflation

Interest rates are a useful means of controlling inflation by influencing consumer spending. However, many people misunderstand the role of inflation in a modern economy. Modest inflation is needed to ensure that prices and wages increase, which allows the economy to grow. Negative inflation reduces the real value of assets and funds, while high inflation often precedes an economic crash.

In tandem with the UK government, the Bank of England aims for inflation to be 2%, give or take one percentage point. If the inflation rate is more than 3% or less than 1%, the Bank of England must write to the UK government and explain the circumstances.

Historical events and the UK base rate

Since the 1970s, the UK base rate has tended to fluctuate between 5% and 15%, with peaks and troughs reflecting political and economic events. Below, we look at some critical events that have historically influenced interest rates.

1979, Margaret Thatcher and the Conservative government

After taking the helm of the UK in the aftermath of a Labour government, which had allowed inflation to get out of control, the Conservative government immediately increased interest rates. This blunt monetary tool increased the cost of borrowing, reduced consumer spending, reduced inflation, and impacted business investment. In addition, the increase in the base rate led to a stronger currency, making imports more affordable at the expense of exports, which became less competitive.

The 1980s’ economic boom

The UK base rate remained relatively high through the 1980s to control a buoyant, sometimes excessively so, UK economy. During this period, we saw the introduction of the council house “right to buy” scheme, which lit the blue touch paper of the UK housing boom. Deregulation also saw a booming stock market until the crash in 1987 and the subsequent economic downturn.

September 1992, “Black Wednesday”

The disastrous European Exchange Rate Mechanism (ERM) led to “Black Wednesday”. As speculators began to attack sterling, believing it could no longer remain shackled to ERM exchange rate limits, the UK government had to react. On 16th September 1992, the UK government increased the UK base rate to 12%, with suggestions of a further increase to 15%. This flawed attempt to protect the UK’s membership of the ERM saw a collapse in sterling, eventually forcing the UK to withdraw from the European ERM. This marked a change in the UK’s relationship with the European Union, eventually leading to Brexit.

May 1997, the emergence of Tony Blair

The aftermath of “Black Wednesday” prompted a resurgence in the UK economy, creating a constant battle with rising inflation. While in a different range to previous years, between 2003 and 2007, we saw the interest rate increase significantly to combat inflation.

Over the years, there have been various changes to who decides interest rates and what they’ll be. On 6th May 1997, for the first time since being nationalised in 1946, the Bank of England was given operational independence from the government by the then Chancellor of the Exchequer, Gordon Brown. This move led to the creation of the Monetary Policy Committee (MPC), a body of economists empowered to set the Bank of England base rate.

2007/8, the US sub-prime mortgage crisis

In 2007/8, we saw a collapse in the US subprime mortgage market, which eventually led to contagion and a global financial crisis. An overheating US economy, homeownership boom, and competition in the mortgage market had prompted some subprime mortgage companies to take undue risks. When homeowners fell behind with repayments, and cash flow dried up, this placed pressure on sub-prime mortgage lenders and the complex mortgage bonds sold on Wall Street. The functionality of the global banking system was suddenly under threat!

The resulting fall was dramatic; the UK base rate fell from 5.75% in July 2007 to just 0.5% in March 2009 as central banks struggled to contain the crisis. A subsequent fall to 0.25% in August 2016 and a short-term rebound to 0.75% in August 2018 would follow.

In tandem with the reduction in interest rates, the Bank of England had to introduce Quantitative Easing (QE) into the mix. This move saw the bank purchase financial assets on a colossal scale in return for access to Central Bank reserves. Consequently, liquidity was maintained within the banking system, helping to avert a full-blown liquidity crisis.

However, markets were still feeling the impact of the US subprime mortgage crisis more than a decade later.

2020, COVID-19

Even before COVID-19, there was little prospect of the UK base rate returning to anywhere near “traditional” levels. When COVID-19 emerged, this led to an unprecedented campaign by governments to shore up economies. A collapse in consumer spending, struggling businesses, and the threat of sky-high unemployment effectively forced the Bank of England to reduce the base rate to 0.1%. This rate prompted talk of negative UK interest rates to encourage consumer spending and business investment.

2021, the interest rate cycle begins to turn anew

UK interest rates hit an all-time low of 0.1% on 19th March 2020 amid concerns about the short to medium-term prospects for the UK economy and property prices. While this ensured a constant flow of cheap finance for individuals and businesses, it further decimated savers’ returns on funds on deposit.

The housing market benefited from lower mortgage rates, fuelling continued interest from first-time buyers and buy-to-let investors. Many people also took the opportunity to refinance their debts at record-low rates. However, while many continued to gorge on cheap finance, the Financial Conduct Authority (FCA) was becoming concerned about debt levels for individuals and businesses.

Fast forward to 16th December 2021, and finally, the governor of the Bank of England announced an increase in the base interest rate. Rates were increased by 0.15 percentage points to 0.25% amid concerns that inflation was becoming a significant issue.

As countries worldwide began to exit the coronavirus pandemic, demand for products and services soared. In hindsight, this prompted what is now a full-blown cost-of-living crisis caused by supply issues, commodity price rises, and wage inflation as businesses struggled to keep up with demand.

While nobody could have forecast the resulting cost of living crisis, many believe policymakers were too slow to react.

2022, an unexpected cost of living crisis

The Consumer Price Index (CPI), the most common measurement of inflation in the United Kingdom, entered 2021 at just 0.6%. However, by year-end, it had risen to 5.4%. Growing concerns prompted the Bank of England to increase base rates to 0.5% on 3rd February, with a further increase to 0.75% on 17th March. In addition, the Ukraine crisis has caused a massive spike in gas and electricity prices, adding fuel to the fire of the rising cost of living.

In February 2022, inflation stood at 6.2% and was forecast to peak at over 8%, but it would eventually hit double digits.

What is expected from the BOE in early 2023?

Many wait with bated breath to see what the central bank will do with interest rates in early 2023. Sadly, it is unlikely to be good news, and there is speculation that the base rate will continue to rise to combat inflation.

In fact, after the February MPC meeting, the Bank of England announced that the base rate had been increased to a 14-year-high of 4%, which will undoubtedly put a lot of pressure and stress on homeowners and businesses.

The BoE has said that although inflation has started to come down, it has yet to reach an acceptable level. With this in mind, it looks as though the central bank will continue to increase rates, at least during the earlier part of 2023.

The history of interest rates in the UK

When you consider the UK base rate rarely strayed below 4% or above 5% during the 18th century, recent fluctuations are even more striking.

Since the 2007/8 US subprime mortgage collapse, base rates worldwide have been at near-record lows, even after recent increases. In addition, the emergence of COVID-19 forced governments to invest vast amounts of capital in supporting their economies. However, the spectre of inflation has introduced a two-way pull, supporting economies with low interest rates while curtailing spending to dampen inflation.

While the interest rate on government borrowings is minimal, they will still need to pay back their substantial capital borrowings at some point. While the double whammy of the US mortgage crisis and the emergence of COVID-19 saw UK base rates hit a record low, nobody expected the ongoing cost of living crisis. What next for UK interest rates?