What’s Behind the Base Rate Hype?

November 1, 2017

 

There has been much debate over when the Bank of England will raise interest rates and this month is tipped to be the month by many industry commentators. In this blog post I thought it would be useful to review what the Bank of England Base Rate actually is, and why it is such a hot topic of media speculation.

 

What is the Bank of England Base Rate?

 

The Bank of England (BoE) Base Rate is the interest rate at which the BoE lends to banks. A committee from the BoE, known as the Monetary Policy Committee (MPC), meets eight times a year (usually during the first week of the month) to decide what the base rate should be.

 

The Purpose of the MPC

 

The primary aim of the MPC is to ensure ‘price stability’, that is to ensure that the cost of living isn’t increasing too quickly, or too slowly. Price stability is measured by inflation, and specifically by the Consumer Price Index (CPI).

 

The Government’s target rate of CPI is 2% and the MPC is tasked with keeping inflation as close as possible to this target.

 

How Does the Base Rate Influence Inflation?

 

There are many interrelated factors that impact on inflation and our wider economy and it is simplistic to suggest that a direct and isolated relationship exists between any of them. However, all other factors being equal, two of the key reasons the base rate influences inflation are:

 

Consumer Spending

 

Low interest rates make savings less attractive and borrowing more attractive. This encourages us to spend more, so increasing the demand for products and services and encouraging growth. The law of supply and demand means that the more demand there is for products and services, the higher the cost of those services becomes.

 

The reverse is true when interest rates are high. It becomes more attractive to us to save money than to spend it or borrow it, we therefore spend less and the cost of products and services is driven down.

 

The Cost of Imports

 

When interest rates are low, investment in Sterling becomes less attractive relative to other currencies and its relative value reduces. The cost of importing goods from abroad is therefore more expensive and this is reflected in inflation figures.

 

Again, the reverse should be true. A rise in interest rates will make Sterling a more attractive investment, there will be more demand for it and its buying power is enhanced. We have more ‘bang for our buck’ when it comes to foreign goods and services so their relative cost is reduced.

In reality, things are far less predictable than these broad principles might suggest and there is also a time lag before changes in interest rates affect spending, and in turn inflation.

 

 

Inflationary “Trade-Offs”

 

The MPC is also tasked with supporting Government’s economic policies and helping it to meet growth and employment targets, so they have the discretion to ‘trade-off’ inflationary considerations to boost other economic indicators.

 

If the MPC feels that the state of the economy is such that increasing interest rates would increase the risk of mortgage defaults for example, they might choose to hold off on raising rates despite the risk of failing to achieve target levels of inflation.

 

Current Considerations

 

The BoE Base Rate is currently at a record low of 0.25%. It was reduced by 0.25% last year to try and ward off a ‘post Brexit’ recession, having been maintained at a record low of 0.5% since 2009.

 

So what are the key factors for the MPC to consider this month?

 

Arguments for a Rise

 

Inflation: Inflation is above target. After three years of inflation being below target, CPI is currently around 3%.

Growth: Growth, as measured by GDP, was more positive than expected last month, perhaps providing confidence that the economy could cope with a rate increase.

Signalling: Telling the market what you are going to do in advance of doing it is one ‘tool’ that has been used by the Governor of the BoE. Markets react to what they think is going to happen, so that some of the effects of a rate rise can be achieved before the rise actually takes place. For this tool to be effective people need to maintain faith in it and the bank has been warning of a rate rise for a while. A reversal would damage faith and potentially hamper the effect of future policy changes.

Market Reaction: The market’s reaction to the Bank’s signalling has been fairly rational and relaxed, indicating that a rate rise would be tolerable.

 

Arguments Against a Rise

 

Growth: Although growth was stronger than expected in October, it is still relatively weak. Poor productivity is a key factor in this weak growth which wouldn’t be helped by higher rates.

Wages: Wage growth is not keeping pace with inflation so in real terms we are becoming poorer. This is likely to slow the economy which will have a knock on effect on inflation without the bank needing to raise rates.

Indebtedness: UK household debt is high relative to income and a rate rise would make servicing this debt more costly. The risk of defaults on mortgages and other credit is a serious consideration, particularly as the UK housing market is reported to have ‘cooled’. 

 

Will We See A Rate Rise in November?

 

November’s decision could go either way but if we do see a rate rise it is likely to be a 0.25% increase and nothing more for now. We expect that the MPC will wait to see what impact this has on consumer confidence before voting for further rises.

 

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