Article
Written by James Woodman
Posted on 10/08/2018

Interest Rates: Are we walking on an economic tightrope?

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In the aftermath of the 2008 financial crisis, central banks around the world embarked on a policy of quantitative easing, in a bid to keep alive consumer spending, and economies, such as the UK, reliant on the service sector, afloat.

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There had been much speculation in the last 12 months about an imminent decision from the Bank of England to raise interest rates, but up until now, there have always been factors which have prevented an agreement amongst the Monetary Policy Committee (MPC).

Now, in the most recent meeting, on 2nd August, the committee voted unanimously (9-0) in favour of increasing rates for the first time since July 2007, taking the base rate up from 0.5% for the first time since 5th March 2009.

What does this change mean?

For consumers:

For many consumers, in the initial days and weeks following the increase, very little will change.

The immediate concern is for households who are currently on variable rate or ‘tracker’ mortgages. More than 3.5 million residential mortgages are currently on a variable or tracker rate, with the new rate of 0.75% adding a typical annual cost of £224 to a mortgage of £150,000.

For businesses:

The second consideration is the effect on SMEs – the lifeblood of the British economy, making up 99.9% of all private sector businesses in the UK. Small-business owners are likely to see a rise of around 7% on their loans, an additional margin that they will already need to find, at a time where consumer spending is falling, and the economy is growing at a sluggish pace – the BoE is only predicting GDP growth of just 1.4% for 2018, following disappointing figures of just 0.1% in the first quarter.

The monetary policy committee of the Bank of England has been evaluating the strength of the UK economy for some time, with a keen eye on balancing the inflation rate in the face of rising wages resulting from record levels of employment.

The concern from the MPC is that is concerned that increased wages and business competing for labour will lead to prices rising in shops, thus triggering a jump in inflation.

For banks:

The profit margins of high-street banks have been suppressed for some time, with a low base rate meaning that the market has been very competitive, with low-interest mortgage deals, as well as external competition from loan providers in markets such as the car industry offering 0% finance deals.
Instead, banks are using the rate change as an opportunity to widen profit margins.

Despite the increase in rates meaning that banks can charge more interest on outstanding consumer debt, for tracker-rate mortgages for example, evidence is showing that the increased rates are not being passed on to savings accounts in such a hurried fashion. Whilst some home-owners and businesses are seeing their mortgage rates rise by around 0.25%, most savers are seeing fairly modest rises of 0.07%.

Having made this change, no further changes to the interest rate are expected until the middle of 2019 at the earliest.
 

Too soon?

The big question is, how soon is too soon to ‘normalise’ policy and reduce quantitative easing?

Both the UK and the global economy are still in a fragile state, with the recovery so far stabilised by a base of cheap lending, which has encouraged a reliance on borrowing. The UK’s private debt sits at 217% of GDP, while the public finances sit at around 90% of GDP, the recovery is hardly in full swing... 

We’ve already started to see the impact of large debt piles on the retail industry, with household names such as Maplin, Toys’R’Us and House of Fraser, all losing the fight. 
Central banks need to wean economies off of cheap borrowing, but will there be more short term pain as the economy tries to go ‘cold turkey’?