Why have interest rates been raised? And what’s the impact?

The Bank of England raised interest rates for the first time in a decade today, raising its main rate by 0.25%-points to 0.5%. What are the reasons behind the rise and what does it mean for the economy and for households?

How much have rates gone up by?

The Bank of England, via its nine-member Monetary Policy Committee (MPC), is responsible for setting interest rates. The MPC’s main requirement is to deliver low inflation, defined as a 2% annual increase in the Consumer Prices Index (CPI).

At its latest policy meeting, the MPC voted by a majority of 7-2 to increase its official interest rate, called the Bank Rate by 0.25%-points to 0.5%. This is the key interest rate in the financial system. Changes to it feed through to the rest of the banking and financial system. In turn, this affects the savings rates and interest rates on loans for consumers and businesses.

What’s happened since rates were last raised in 2007?

The last time the MPC increased interest rates in July 2007, they were at 5.75%. The financial crisis and severe economic recession in 2008/09 led to rates being cut all the way down to 0.5% by March 2009 in an effort to support the economy – the lowest they had been in the Bank’s over-300-year history. Rates were left unchanged for over seven years until they were cut to 0.25% in August 2016, shortly after the Brexit vote, and remained there until today.

Chart showing drop in interest rate from 5.57% in July 2007 to 0.5% in March 2009

The UK is not alone in seeing interest rates close to zero. Central banks in major advanced economies have set either very low, or even negative interest rates.

Why did the Bank of England raise rates?

At face value, this seems straightforward: consumer price inflation is well above the MPC’s 2%-target at 3.0%. Traditionally, to get inflation down, interest rates are raised to make it more expensive for banks to borrow money and, in turn, companies and individuals. Once this has filtered through the financial system, the expected result is less spending in the economy, which reduces inflationary pressures.

A large part of the recent increase in inflation is due to past falls in the pound on foreign exchange markets since early 2016 and, particularly, following the Brexit vote in June 2016. This made imports more expensive and pushed up prices in the UK.

Chart showing consumer price index

We expect that this exchange-rate effect will slowly fade from the annual inflation rate, which measures the change in prices over the past 12 months. Indeed, for this reason, the Bank of England and most economists expect inflation to be peaking now at around 3.0% and for it to come down somewhat in 2018 (though remain above the 2%-target).

In isolation, the MPC might be expected to “look through” the impact of the exchange rate and not alter policy. This is indeed what the MPC was indicating it would do until fairly recently; the expectation of economists and financial markets was that rates wouldn’t be raised until well into 2018 at the earliest.

However, a change in tone in the communications of the MPC and its members, including Bank of England Governor Mark Carney, in the summer and early autumn forced observers to change their views. In recent weeks, the MPC has clearly been signalling that interest rates were likely to go up soon, as proved to be the case.

So why now?

Economic growth has remained steady but subdued, with a quarterly GDP growth rate of 0.3%-0.4% in each of the first three quarters of the year. Forecasts for the next few years are for similar growth rates to continue. This is below the trend of recent years when growth averaged 0.6% per quarter during 2013-2016. In addition, average wage growth is still modest at around 2% annually, despite unemployment being at a 40-year low.

In themselves, economic and wage growth at these rates would not in the past be considered sufficiently inflationary for rates to be raised, but there are two additional factors that need to be considered. The first is that since the MPC’s rate cut in August last year following the EU referendum, economic growth has actually been faster than was forecast by the MPC at the time.

The other more important point is that expectations of the rate of growth the UK economy can comfortably achieve without generating inflation has been downgraded by the MPC. In other words, longer-term growth prospects are viewed as weaker than was previously thought: the MPC estimates that this is now 1.5% per year compared with 2.7% before the financial crisis. This means the MPC forecasts of GDP growth of 1.6-1.7% in the next three years is “just above potential”.

One key factor behind this view is the decade-long stagnation in UK productivity. Previously, it was assumed by most that productivity growth – the most important factor in the growth potential of an economy – would return to its pre-crisis average of 2% per year. A lower potential long-term rate of growth means that inflationary pressures build up at lower rates of growth. In turn, this provides more reason to raise interest rates at these lower rates of growth. The MPC also cited the Brexit vote as another factor, although not as important as productivity, in reducing the economy’s long-run growth potential.

What’s the impact on households?

Very low interest rates have made it very cheap for consumers to borrow. With consumer debt (excluding mortgages) rising by around 10% annually, there has been concern that some consumers are overextending themselves. A rate hike may temper the growth in credit, although it could also make it more expensive for those with debts to keep up with repayments.

The interest rate set by the Bank of England is a crucial factor in determining borrowing costs and savings rates. However, it is up to individual banks and financial companies to set the interest rates they offer consumers. Many will pass on the rate increase in full but this is not guaranteed.

Should the rate rise be passed on, it will make it more expensive to borrow money and raise returns from savings accounts. Given interest rates remain very low, a quarter-point increase will not dramatically change things.

For every £1,000 in savings, an extra £2.50 a year will be received if savings rates go up by 0.25%-points. So for every £10,000 an individual has saved, they will receive an additional £25 per year.

Of the roughly one-third of all households with a mortgage, 57% are on fixed-rate mortgages (88% of new mortgages are on fixed rates) meaning this rate increase will not immediately affect them, although they may well face higher interest rates once their fixed-term comes to an end.

The other 43% on variable rates (including trackers) will see their monthly payments increase. Some estimates are provided in the table below. For a household still owing £100,000 on their mortgage, an increase in their interest rate from 3.0% to 3.25% will see their monthly repayment go up by £13 per month (assuming there is 20 years left on the mortgage).

Photo credit: Bank of England / looking up, by George RexCreative Commons Attribution 2.0 Generic (CC by 2.0)