StudySolver – News and Tips for Studying

In November 2nd 2017, The Bank

In November 2nd 2017, the Bank of England raised the interest rate for the first time in over a decade. It has been raised by a quarter of a percent up to 0.5%, which indicates the likely start of a likely increasing cost of borrowing money.

However this is unlikely to be the final figure, the bank’s Monetary Policy Committee has stated that there will be a minimum of two more quarter percentage increases over the next two years in order to control the rising inflation in the UK markets. The Bank of England would normally increase interest rates when the economy is in a period of overheating – this is when both consumer and business demand are accelerating, with the current environment this is not the case. Although employment levels are high, the economy is performing very badly in almost all other aspects, and productivity has steadily declined and stalled ever since the financial crisis in 2008/09; business investment is static, there is a large trade deficit, and most importantly, real earnings (after inflation) have begun to decline, in fact most people have not seen a rise in pay since 2005 and the UK is currently experiencing its longest period of wage stagnation for 150 years.

The reason for the Bank of England deciding to increase the interest rate can be traced back to the UK’s decision to leave the European Union. Immediately following the decision the value of the pound sterling dramatically decreased compared to other currencies thus making everybody in the country poorer and cutting into real wages. So whilst the demand remains at the same level, people and businesses based in the UK have less money to spend. The consequences of this is an increase in inflation; taking the example of food sold in supermarkets, many food products are imported from other countries but due to the devaluation of the pound it now costs more money for supermarkets to import them to sell in their stores, this means that in order to maintain a profit on these items the prices must increase. This is the same for all other markets within the economy and has led to an increase in inflation to 3% as of November 2017.

The legal mandate is to ensure that inflation is no higher than 2%, the Bank of England has only one tool to combat inflation rates above 2% and they have just used it.

Some of the effects of the increase in interest rates are as follows:

Monthly mortgage payments are likely to increase. This will quickly affect people on tracker mortgages, for example someone paying 2% interest on a 25 year £250,000 repayment could see their monthly £1100 instalment rise by roughly £30 with the increase, however due to the fact that more and more people are moving away from tracker mortgages this will affect fewer homeowners than before – around 57 per cent of the total stock of mortgage loans are on a fixed-rate basis.

For people looking to take out a loan, the average interest rate on borrowing £5000 has dropped from 9.3% before Brexit to 8%. This drop has been driven by the central bank’s cut in interest rates in August 2016, and if that decision was reversed, unsecured borrowing costs are likely to rise. But a minority of households struggle with debt – credit ratings agency Moody’s said earlier this month that a hike in interest rates could create difficulties for poorer households. [7]

Finally, for consumer able to save, a rise in interest rates will result in them seeing a boost in the interest they earn on their current account deposits. An increase could improve the payback on instant access savings accounts, which have dropped to around the 0.1 per cent mark from 0.4 per cent in June 2016. [7]

Another benefit of higher interest rates is that the value of a currency can increase. Due to the UK’s decision to leave the EU and value of the pound has declined but, by raising the interest rates, the Bank of England can help to restore the value of the pound. Because of hot money flows, investors (particularly foreign) are more likely to save in British banks if the UK interest rates are higher than those in other countries. By having a stronger pound, UK exports will become less competitive; exports will reduce and imports will increase.

To conclude, if the interest rates increase it then becomes more expensive to borrow money (as a larger amount must be paid on top of original borrowed sum) and more beneficial for people to save money (as banks will pay more for saving). This means that consumers are less likely to take out money and more likely to store money in the bank. This means that there will be a fall in consumer spending and investment. Likewise with firms, which will be less likely to invest in new capital (due to borrowing the necessary funds to buy it now costs more) and they are more likely to save profits. The reduction in both consumption and investment means that aggregate demand (AD) will fall which can be represented in a shift to the left in the diagram.

Having a lower AD will cause higher unemployment, if output falls firms will produce less goods and will need fewer workers; and lower economic growth (and possibly a recession).