Interest rates play a crucial role in shaping the UK economy, influencing borrowing costs, spending patterns, and investment decisions for companies and individuals. The Bank of England (BOE), the country’s central bank, is responsible for setting and adjusting the base rate, from which banks, building societies, and financial institutions then set their own rates on their loans and savings products.
Over the past 12 months, interest rates in the UK have increased rapidly. As of June 2023, the base rate is at its highest level since the financial crisis. The BOE has recently implemented a rate increase for the 12th consecutive time following a meeting of the Monetary Policy Committee.
But when will interest rates go down? Will they reduce by the end of the year? Or next year? Or even in two years’ time?
Sadly, answering those questions correctly is extremely difficult – even for highly experienced economists. Bearing that in mind, this article explores the reasons behind interest rate adjustments, discussing both rate reductions and interest rate hikes and delving into the challenges of accurately predicting long-term rate forecasts.
Why interest rates are central to the health of the UK economy
Before looking at what may influence a rate cut for the first time since last year, it’s good to know why the base rate is so important.
The BOE base rate helps shape the overall health and stability of the UK economy. The ability to adjust interest rates is a powerful tool the Bank of England wields to influence various sectors and economic indicators. Here’s how:
Interest rates serve as a key instrument of monetary policy. The Bank of England adjusts these rates to manage the money supply, control inflation, and stimulate or moderate economic growth. By manipulating borrowing costs, the central bank influences consumer spending, business investment, and overall economic activity. Thus, interest rates form a critical mechanism to fine-tune and steer the economy toward stability and growth.
Interest rates directly impact the cost of borrowing for individuals, businesses, and the government. Lower interest rates make credit more affordable, stimulating borrowing and consumption. This encourages investment in businesses, promotes entrepreneurship, and fuels economic expansion. Conversely, higher interest rates can curb borrowing, temper excessive spending, and promote savings, contributing to financial stability and preventing overheating in the economy.
Interest rates play a vital role in managing inflation, which refers to the general price increase. When inflation rises beyond a target range, the Bank of England may increase interest rates to reduce excessive spending and rein in inflationary pressures. Conversely, lower interest rates can stimulate spending during economic downturns, preventing deflation and supporting price stability.
Interest rates impact the financial sector, influencing investment decisions, asset prices, and market stability. Moderate interest rates foster an environment conducive to investment, as businesses can access affordable financing to fund expansion and innovation. Stable financial markets attract investors and maintain economic confidence, fostering long-term growth and resilience.
Why interest rates are important to the average UK citizen
Interest rates directly impact the average person in the UK, influencing various aspects of their financial lives. Here are some ways they could affect you:
When interest rates are low, it becomes cheaper for individuals to take out loans, such as mortgages, car loans, or personal loans. Personal finance borrowing becomes more affordable and enables people to finance big-ticket purchases or investments thanks to better rate deals available. Conversely, higher interest rates increase borrowing costs, making even a loan with the best five-year rate more expensive and potentially limiting individuals’ ability to access credit.
Interest rates also affect savings and investments. When interest rates are high, savers earn more interest on their deposits, encouraging them to save and build financial reserves. On the other hand, lower interest rates reduce the returns on savings accounts, prompting individuals to explore alternative investment options to grow their wealth.
For homeowners with variable-rate mortgages, changes in interest rates directly impact their monthly mortgage payments. When interest rates rise, mortgage payments increase, potentially straining household budgets. Conversely, lower interest rates can reduce mortgage payments, giving homeowners more disposable income.
Interest rates and inflation are closely linked. Individuals ‘ purchasing power can increase when interest rates are higher than the inflation rate. This means their money’s value is growing at a faster rate than prices, enabling them to buy more goods and services. Conversely, if interest rates lag behind inflation, purchasing power diminishes as the cost of living rises faster than the return on savings.
Why does the Bank of England lower UK interest rates?
One of the primary objectives of lowering interest rates is to encourage economic expansion. By reducing borrowing costs for individuals and businesses, lower interest rates incentivize borrowing and spending. This, in turn, stimulates consumption, investment, and overall economic activity. When people can access credit at lower rates, they are more likely to make purchases, start new businesses, and invest in capital projects. These actions contribute to job creation, higher incomes, and economic growth.
That’s because lower interest rates help with all the below factors.
Controlling inflation is a key consideration for the Bank of England. Lowering interest rates can help manage inflationary pressures by stimulating spending and economic activity. When demand increases, businesses may expand production, leading to more competition and lower prices. Lower interest rates can make it more affordable for businesses to invest in productivity-enhancing measures, such as technology upgrades or research and development, which can improve efficiency and restrain inflationary pressures.
Lower interest rates benefit existing borrowers by reducing their debt costs. This provides relief for households and businesses with outstanding loans, allowing them to allocate more funds toward other expenditures or investments. Lower interest rates can also make it easier for individuals and businesses to access credit, promoting financial stability and facilitating debt repayment.
Lowering interest rates can also impact a country’s exchange rate. When interest rates are lower compared to other countries, it can make domestic assets and investments relatively less attractive to international investors. This can lead to a depreciation in the value of the domestic currency, making exports more competitive and supporting economic growth through increased international trade.
Why would the Bank of England implement an interest rate rise?
As seen since the pandemic, there are plenty of times and circumstances in which the BOE may choose to implement an interest rate rise. By increasing borrowing costs, the BOE aims to moderate demand, promote financial system stability, and address emerging risks. It is a tool employed to maintain price stability, support responsible borrowing and lending practices, and safeguard the overall health of the UK economy. Here’s how an interest rate rise can help achieve that:
As maintaining price stability is a fundamental objective of the BOE, the central bank may opt for an interest rate rise if it rises above the desired target range. By increasing borrowing costs, the BOE aims to moderate excessive spending, dampen demand, and curb inflation. Higher monthly payments, for example, on a fixed-rate mortgage, will affect affordability in the housing market. Plus, a higher interest rate encourages individuals and businesses to save more and borrow less, thereby reducing aggregate demand and slowing down price increases.
A key consideration for the BOE is maintaining overall financial stability. When interest rates are too low for an extended period, it can encourage excessive risk-taking. Implementing an interest rate rise can act as a preventative measure to mitigate the potential risks associated with asset bubbles, high debt levels, or speculative activities. It promotes a more prudent approach to borrowing and lending, safeguarding the financial system’s stability.
The Bank of England may raise interest rates to influence the national currency’s exchange rate – just as lowering it can. A higher interest rate can attract foreign investment, increasing demand for the currency and potentially strengthening its value. A stronger currency can have various benefits, including reducing import costs, containing inflationary pressures, and enhancing the purchasing power of individuals and businesses.
The Bank of England may identify specific financial imbalances that require correction in certain situations. These imbalances could arise from rapid credit growth, overheating of certain sectors, or high-risk investments. Raising interest rates can help mitigate these imbalances by making borrowing more expensive, encouraging deleveraging, and restoring a more sustainable financial environment.
The Bank of England follows a well-defined process to determine whether to raise, hold, or lower interest rates. It involves a thorough analysis and assessment of various economic indicators and factors. Here are the steps involved:
- Gathering Economic Data: The Bank of England collects a wide range of economic data, including GDP growth, inflation rates, employment figures, productivity, and global economic trends. Data, therefore, provides insights into the current state of the economy and helps identify emerging trends and potential risks.
- Economic Analysis: Bank economists analyze the collected data to assess the economy’s overall health. They evaluate the performance of different sectors, assess inflation figures, and examine the impact of fiscal and monetary policies. The analysis involves considering both short-term fluctuations and long-term trends (such as the direction of food prices or energy prices) to understand the underlying economic conditions.
- Monetary Policy Committee (MPC) Meeting: The MPC, consisting of Bank of England officials such as Andrew Bailey and external experts, convenes regularly to discuss and decide on interest rate policies. During these meetings, members review the economic analysis, exchange views, and debate the potential actions to be taken regarding interest rates.
- Deliberation and Decision-Making: The MPC deliberates on balancing economic risks and considers different scenarios. Factors such as inflation targets, employment goals, and financial stability are all considered. The decision on interest rates is made through voting, with each member having an equal say. The majority view determines the outcome.
- Communication and Announcement: Once a decision is reached, the Bank of England communicates its interest rate decision to the public. The decision is often accompanied by a detailed explanation of the rationale, taking into account the economic analysis, risks, and the outlook for the future.
- Monitoring and Adjustment: After implementing the decision, the Bank of England continuously monitors the economy and adjusts interest rates as necessary. If economic conditions change significantly or new risks emerge, the Bank may modify its stance to ensure monetary policy remains appropriate.
Having a structured approach ensures careful consideration of various factors before determining the appropriate course of action for interest rate policies. For some market commentators, it also helps them make a more informed estimation of the path of interest rates – though it is still tough to predict what the MPC will decide accurately.
Forecasting long-term interest rates in the UK is a complex task involving considering various factors and uncertainties. The dynamics of the global economy, ever-changing market conditions, and unforeseen events make it challenging to accurately predict the direction of interest rates over an extended period.
Economic variables and Interdependencies
Numerous economic variables influence interest rates, such as GDP growth, inflation, employment levels, and productivity. These factors are interconnected and subject to constant change, making it challenging to project their future trajectory accurately. Moreover, the UK economy is highly interconnected with the global economy. Changes in global interest rates, trade policies, or geopolitical events can significantly impact the UK economy and subsequently influence interest rate decisions.
Unexpected events like natural disasters, political crises, or major technological advancements can disrupt long-term interest rate forecasts. For example, Liz Truss’s mini-budget played havoc on the markets in September 2022 – resulting in lenders withdrawing mortgage deals and those on tracker mortgages being negatively hit exceptionally quickly. The war in Ukraine is another example of a recent event that can lead to higher rates. These unforeseen shocks can create volatility and uncertainty in financial markets. The occurrence of such events is difficult to predict, yet their impact on interest rates can be significant.
Economic data used for forecasting interest rates often suffer from time lags, making it challenging to capture real-time economic conditions accurately. Additionally, economic forecasts are based on assumptions that may change over time. New data and information can emerge, altering the economic outlook and affecting interest rate projections.
The Bank of England, as an independent institution, has the discretion to adjust interest rates based on its assessment of economic conditions. These adjustments are made in response to evolving economic circumstances, which are subject to interpretation and judgment. Central bank decisions may not always align with market expectations or conventional forecasting models, adding another layer of uncertainty to long-term rate forecasts.
Predicting the direction of interest rates in the UK presents a considerable challenge due to the complex interplay of economic variables, global factors, and unforeseen events. While the Bank of England aims to maintain stability and promote economic growth, accurately forecasting rate rises or falls in the long term will always be tough. Nevertheless, understanding the reasons behind interest rate adjustments and the inherent challenges of prediction can help individuals, businesses, and policymakers make informed investment decisions in an ever-changing economic landscape.