Since the 2007/8 US sub-prime mortgage crash, which resulted in a worldwide depression, UK base rates have remained at or around historic lows. During 2018/19 there were fleeting hopes that interest rates would start to move higher, and eventually return to more “traditional levels.” However, in light of Brexit and COVID, it is safe to say these hopes have been somewhat dashed!
Historic UK interest rates
Before we look at the outlook for UK interest rates in 2021, it is useful to remind ourselves of the recent change in UK interest rates. The Bank of England’s Monetary Policy Committee (MPC), which regularly considers factors influencing interest rates, decides these changes.
This graph is undoubtedly a “game of two halves” with interest rates at more traditional levels in the first half and hovering around historic lows in the second. The deterioration in UK interest rates around 2008/9 was a direct consequence of the US sub-prime mortgage market collapse.
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As you can see from the following graph, the Consumer Price Index (CPI) flirted with sub-zero levels during 2014/15. This is the traditional measure of inflation, although the MPC will also take account of:
- Owner Occupiers Housing costs (OOH)
- Consumer Price Index including Housing costs (CPIH)
The MPC also has one eye on the economy, including current performance and prospects for the future, and the likelihood of any significant economic or political shocks in the future. It is fair to say that the MPC’s role is pivotal to the performance of the UK economy.
Factors impacting UK interest rates in 2021
There are numerous factors to consider regarding UK interest rates and economic performance in 2021. These include:
Brexit/EU trading relationship
While there was surprise (and excitement) when Boris Johnson announced a free trade agreement with the EU before Christmas, the Bank of England had already factored in this scenario. Nevertheless, it was a welcome relief when the deal was announced – although as ever the devil will be in the detail.
There are still issues to be resolved in the short to medium-term, mainly involving the UK financial services industry. There is presently no agreement to allow UK financial service companies to “passport” their services to EU markets. In 2019 the sector accounted for 6.9% of UK GDP and 11.5% of employment tax revenues.
Even though the significant risks associated with a no-deal Brexit have been removed, there are still potential operational risks in the short-term. Consequently, Brexit may yet have an impact, albeit reduced, on the UK economy in the short to medium-term. Recent minutes from the latest MPC meeting confirm this scenario:
“UK trade and GDP were judged likely to be adversely affected as the United Kingdom adjusted to new trading arrangements with the European Union. At least some short-term disruption appeared likely.”
Impact of COVID pandemic
The COVID pandemic has had, and will continue to have, a significant impact on the UK economy for some time to come. There was much talk of this in the latest MPC meeting minutes released just before the end of 2020. We know the Bank of England is concerned; they have floated the idea of negative interest rates in the UK and spoke about the potential for a double-dip recession. A double-dip recession is an uncommon occurrence, where the economy contracts and recovers, only to contract again.
It was interesting to note recent UK economic forecasts from Goldman Sachs. The US investment banking giant is one of many prominent financial groups also expecting a double-dip recession. Experienced Goldman Sachs economist Sven Jari Stehn believes that:
“Given the return to nationwide lockdown, we now expect a 1.5% contraction in real GDP in Q1, putting the UK economy into a double-dip recession.”
As the current lockdown’s duration is likely to be extended, rather than reduced, the actual economic ramifications may currently be underestimated. A challenging final quarter of 2020 will, when confirmed, likely see annual UK GDP contract by around 11 percentage points compared to 2019. The emergence of a double-dip recession would be the first such event in the UK since the mid-1970s.
Prospects for UK interest rates
While the idea of negative interest rates in the UK will surprise many, it is a distinct possibility. The Bank of England is likely to wait for further details on the UK/EU trading arrangement before reacting. However, the COVID pandemic’s impact will likely be the most significant deciding factor in the future.
On the plus side, the UK government has managed to secure enough vaccine doses to cover the whole UK population. There has been encouraging progress in administering the vaccine so far, which has given the Bank of England an enhanced degree of optimism. A successful rollout of the vaccination programme would see restrictions removed in the coming months. This could then likely precipitate a strong rebound in the UK economy in the latter part of 2021.
Interestingly, there have been some revisions in the economic forecasts released by Goldman Sachs:
- 6% GDP growth 2021 (previous forecast 7%)
- 4% GDP growth in 2022 (previous forecast 6.2%)
This level of performance should still stave-off further reductions in UK interest rates. However, Laith Khalaf, a financial analyst at AJ Bell, believes that markets are currently pricing in a “one in four chance of a rate cut in 2021.”
This would see UK base rates fall to zero or even into negative territory.
Why are negative interest rates so controversial?
The concept behind negative interest rates is simple, encouraging consumers and businesses to spend and invest. This would, in turn, lead to:
- Increased consumer spending
- Greater demand for goods/services
- Prompt a recovery in business activity
A reduction in interest rates would likely see a fall in the sterling exchange rate against leading counterparts. Therefore:
- Encouraging exports by making UK goods cheaper in dollar and euro terms
- Although it would prompt a rise in the cost of imports
The Bank of England has already confirmed a willingness to deviate from its long-term inflation target of 2%. This would be a relatively small price to pay for a short to medium-term boost in economic activity.
The real impact of negative interest rates on mortgage rates, loan rates and credit cards would likely be minimal. For example, many mortgage providers have a minimum rate at which they will cease reducing mortgage rates in line with interest rates. It is also important to appreciate that negative interest rates would only be a short-term phenomenon. Other financial levers are also available to the Bank of England, such as quantitative easing and targeted financial assistance.
There is no doubt that the UK/EU trade agreement has reduced, at least in the short-term, the chances of a further reduction in UK interest rates. Against this background, it is essential to remember there is little to no chance of an increase in UK base rates in the foreseeable future. The key now is the COVID vaccination programme, the lifting of restrictions and the expected sharp recovery in the UK economy. The Bank of England has recently reaffirmed that, if required, they will take additional action before the next scheduled MPC meeting in February. It would be remiss to suggest that we are out of the woods just yet.
There are encouraging signs that interest rates may have bottomed out, and reasons to be optimistic, but the road to recovery will be long and challenging. A move back to “more traditional” interest rate levels is a long way down the road.