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Yesterday, the Bank of England’s Monetary Policy Committee (MPC) decided to raise interest rates from 0.25% to 0.5%, the first increase in over 10 years. The rate rise, that had been expected for a while, is in response to rising inflation, which hit 3% in mid-October, a five and a half year high. The UK’s gross domestic product also grew by 0.4% in the third quarter of 2017, exceeding expectations further increasing the probability of the rate rise.Changing interest rates can lead to volatility in markets, as the interest rate dictates how much a lender can charge for loans, the cost of borrowing for a consumer, the return on savings for consumers as well as affecting currencies, prices and trade.
In August 2016, the interest rate was reduced to 0.25%, the first reduction since 2009 and a UK record low. The Governor of the Bank of England Mark Carney cited Brexit as the main reason, stating that the lower interest rate could “reduce uncertainty, bolster confidence, blunt the slowdown, and support the necessary adjustments in the UK economy”. Due to the UK economy struggling in the aftermath of Brexit, lowering the interest rate reduced the cost of borrowing for consumers and companies’, thus encouraging further spending as it was relatively cheaper to do so stimulating the economy. It also encouraged investment due to the lower cost of borrowing, which typically leads to economic growth. However the decision to cut interest rates back in August 2016 also led to a depreciation in the pound, and has also caused a spike in inflation, as can be seen in the graph below.
Inflation has been steadily rising since September 2015
By raising the interest rate, the MPC are attempting to stabilise the increase in prices and wages that comes with rising inflation, whilst also normalising the interest rate so that monetary policy can be more effective in the future.
However there are also negative effects that can result from an interest rate rise. If the pound appreciates as expected, foreign investment may decrease due to both the higher cost of the pound, as well as a higher cost of borrowing in the UK, which would negatively affect GDP growth. Exports could also decrease as the cost of UK goods becomes relatively more expensive for those using foreign currencies, which would have a further negative effect on GDP growth. A third effect is that the cost of interest payments for floating rate UK Government Bonds will increase, which could have a negative effect on fiscal policy in the future, whilst they also expected that their decision would cause an appreciation in the pound to further boost exports.
There has been a global focus on interest rate normalisation over the last year, with particular focus on the US Federal Reserve and the European Central Bank (ECB). In September the US Federal Reserve decided to leave interest rates unchanged at 1.25%, but Federal Reserve committee members predicted there would be a rate hike before the end of the year, prompting the dollar to appreciate by 0.4%. The ECB chose to maintain a 0% interest rate, however both the ECB and Federal Reserve did announce they would be tapering their quantitative easing (QE) programmes. Central banks employ QE when they want to stimulate the economy without reducing the interest rate; central banks purchase bonds from financial institutions which provides those institutions with funds, allowing them to invest elsewhere. The ECB have stated they will attempt to half their QE programme, from €60 billion a month to €30 billion a month, while committing to holding interest rates until they strip back their QE programme in full.
For the moment, the UK appears to be the boldest of these three large central banks, setting out a path for other economies to follow. The MPC waits to see what kind of impact their decision has on the economy, but early trading indicates a positive reaction, with the FTSE 100 rising 0.9% on Thursday. Contrary to expectations, the pound fell against most major currencies with analysts citing an emergent view that the Bank of England is not likely to raise interest rates again in the near future and that more than one rate rise had been priced into predictions.
Written by Chris Tynemouth. Edited by Keval Dattani and Natasha-Rega Jones.