Interest rates – one year on from the UK’s rate hike

A recent meeting held by the Monetary Policy Committee has ended with the Bank of England leaving interest rates unchanged at 0.75%. This decision comes 1 year after the first increase in rates since July 2007. Mark Carney, governor of the Bank of England, aims to deliver a 1.5% interest rate over the next three years but as Britain enters the final stages of Brexit negotiations, the big question remains what direction rates will go over the coming years.

Financial Crisis 2008

It is important to firstly understand the reasons for why the Bank of England decreased rates to record lows from 5.5% to 0.5% between 2007-2009. Essentially, the housing market, which played such a large role in bank profits, collapsed and so brought banks and the world economy with it. The UK’s GDP fell by 25% and so - aggressive monetary policy had to be enforced in order to save the economy from further collapse. This revitalization was initially slower than expected, and thus rates remained at 0.5% for the following 7 years in order to stimulate growth, by encouraging investors and consumers to borrow more and save less.

Why raise rates?

As the UK enters the final stages of Brexit negotiations, it seems that the Bank of England is preparing itself for another ‘mini recession’, similar to that in 2016. Therefore we expect rates to continue to rise in order to give more buffer space to any necessary cuts to rates, and thus give the central bank more monetary power. Whilst the aim is to continue increasing rates, the Bank is running out of time with the Brexit deal aimed to be finished by the end of March 2019.

Where will rates go now?

The largest obstacle in the way of increasing interest rates revolves around Brexit, and the potential for another similar contraction in UK output and confidence to what was witnessed in 2016. If the UK’s transition phase into Brexit is smooth, we would expect rates to continue rising at a similar pace in order to escape this ‘liquidity trap’ come the next crisis the UK and other economies may face. Conversely, if the deal strikes more fear into investors, we would expect rates to fall in order to boost spending and mitigate the fall to GDP. This would leave the UK very vulnerable because these cuts may not be enough to counteract this fall in spending, requiring other policy levers such as a continuation of quantitative easing or fiscal stimulus.