August 5, 2016    4 minute read

UK Interest Rate Slashed to 0.25%: Implications

Long-Term Impact    August 5, 2016    4 minute read

UK Interest Rate Slashed to 0.25%: Implications

On top of a new round of quantitative easing, the Bank of England’s Monetary Policy Committee (MPC) has voted in favour of cutting the key interest rate to 0.25%. Although the inflation rate may be higher than the target of 2% for a short period of time, the BoE argues that this trade-off is “appropriate” in order to reduce the level of spare capacity in the economy. In addition, this change is presumably a response to the furore caused by Britain’s recent vote to leave the European Union, with Governor Mark Carney suggesting that the impending “adjustment period” will come at a cost of 250,000 jobs. Interestingly, this is the lowest the rate has been since the financial crisis.

Nonetheless, speaking to BBC News, former BoE committee member Dame Kate Barker insisted that since the base rate is already at 0.5%, further cuts are unlikely to make much, if any difference. Furthermore, lower interest rates will mean reduced demand for the pound, leading to its depreciation and by extension higher import prices, to the detriment of those on lower incomes.

uk infaltion rate

Source: ONS

So, how will these new changes actually affect the two broad types of consumers – borrowers and savers?

Borrowers

In terms of borrowers, clearly, a mortgage is the largest debt or loan any household typically has. Indeed, according to the Council of Mortgage Lenders, approximately 11 million households in the UK partake in a mortgage scheme, whereby the reduction in the base rate will surely result in savings. However, these savings will only apply to some households. Why? Well, an important distinction has to be made between those on fixed term mortgages and those on tracker or variable term mortgages. Only those on tracker mortgages will benefit from the reduction in the interest rate – as the name suggests, their repayments follow or “track” the current interest rate.

According to Hillary Osborne at The Guardian, “for a homeowner on the average variable mortgage rate of 2.86% and a mortgage of £150,000, a reduction in line with the base rate will mean monthly repayments falling by £19.68 to £687”, meaning there is good news for those on tracker mortgages.

Savers

Economics 101 would dictate that the news is bleaker for savers – a reduction in interest rates acts as a tool to incentivise savers to borrow and spend rather than save as returns on savings are now lower. Consequently, this bolsters demand within the economy and aims to stimulate a multiplier effect – eventually leading to even more spending.

What are the ramifications of extremely low-interest rates? Could one see an increase in the volume of investments in the stock market or an even further increase in housing demand perhaps? Of course, this will depend on how averse individuals are to risk. However, with saving accounts now yielding lower returns, households may look for relatively larger (albeit riskier) returns elsewhere.

Conclusion

For the time being, the effectiveness of lower interest rates is somewhat opaque. However, with the base rate already close to zero, the chances of many banks depressing their lending rates onto households and firms are slim. To combat this, the MPC has comprised a solution of launching a so-called Term Funding Scheme to provide banks with liquidity, which they therefore anticipate will be passed onto households and firms through lower lending rates.

One thing is for sure: the success of the lower interest rates will be determined through its effects on consumer and investor confidence.

Get articles like this straight to your inbox each morning with our Breakfast Briefing. Sign up by clicking here!

Log in with your details

or    

Forgot your details?

Create Account

Send this to a friend