Bank of England cuts interest rates to 0.25%: what next?
The Bank of England (BoE) announced a quarter point cut in the UK bank rate to 0.25% at midday today (Thursday), marking the first change in more than seven years.
Shortly after the announcement money markets*, which had priced in 100% certainty of a rate cut, expected a further reduction in November and implied a return to 0.25% in May 2019.
Negative rates are not expected by the markets but a long spell of ultra-low rates is anticipated: a return to 0.5% is implied for April 2021.
The rates decision, made by the monetary policy committee (MPC), is likely to lead to lower rates on mortgages and savings, with some cuts delivered immediately (see Q&A below).
It marks a sharp turnaround from the mood in the months before the EU referendum, when the focus was on predicting when the BoE’s key rate, at 0.5% since 2009, would rise rather than fall. The markets had expected an increase to 0.75% in 2018.
The Brexit verdict dealt a severe shock. It has increased the need to keep supporting the economy with low rates.
How market forecasts for the bank rate changed in the month after Brexit
The BoE has also announced that it would restart its programme of quantitative easing (QE).
QE saw the BoE create £375 billion to mostly buy government bonds, which had the end effect of reducing rates across the economy beyond the effect of bank rate cuts. This programme ran from 2009 to 2012 and has not been unwound.
Today the BoE announced a fresh bout of QE, which includes buying £60 billion of UK government bonds and £10 billion of corporate bonds.
It also announced a Term Funding Scheme (TFS) to "reinforce the pass-through of the cut in bank rate". It will provide funding for banks at interest rates close to bank rate, which may lead to comparisons being drawn with the Funding for Lending Scheme (FLS) launched in 2012.
Azad Zangana, Senior European Economist and Strategist at Schroders, said:
"In the MPC’s meeting minutes, the committee stated that a majority of members are minded to cut interest rates further to close to, but above zero if the incoming data proves to be broadly consistent with their latest forecasts.
"Given our forecast is very similar to the BoE’s, we are today changing our forecast to include a further cut in interest rates to 0.1% for November."
Here, we answer four questions about interest rates.
How and why is the bank rate controlled?
The MPC is charged with using interest rates to balance the economy. It reduces rates to stoke demand and raises them to cool it. As part of this, it has an inflation target of 2%.
The MPC meets for three days once a month and looks at factors that may affect the economy and gauge what might happen in the future to the key consumer prices index (CPI) inflation figure. From September, these meetings will be held less frequently - eight times a year.
Why has the rate been at 0.5% since March 2009?
The recovery from the financial crisis of 2008-2009 has been so fragile that the MPC has viewed it as necessary to keep rates at 0.5%. Inflation has been below 2% since early 2014 and bumped around zero for much of 2015, way below the target. It is therefore judged that low rates and other ways of stimulating the economy are needed.
The level of debt in the UK should also be considered. This is at historic highs for the UK government, and remains relatively high for British consumers and companies. Higher rates would increase the burden of those debts, offering another consideration for the MPC.
How does the bank rate affect other rates, such as mortgage and savings rates?
The bank rate heavily influences consumer rates, in fact some mortgage deals are directly linked to it. Holders of “tracker” mortgages should see an immediate cut, unless their deal has a “collar” – a minimum level. Banks will reduce standard variable rate mortgages, or SVRs, at their own discretion.
The pricing of new mortgage and savings deals - rather than existing accounts - can also be affected by the mere expectation for the bank rate. As the chance of rate cuts has risen, lenders have responded by improving mortgage fixed rate best buys in the past month.
But other factors are at play in keeping rates low, aside from the bank rate.
Schemes were devised by the central bank after the financial crisis with the aim of driving down borrowing costs, including QE and the FLS. So while the bank rate was fixed at 0.5% for more than seven years, mortgage and savings rates fell sporadically during those years. They fell particularly sharply after FLS.
Bank of England data shows that in the past five years, the average rate for two-year fixed rate savings bonds has fallen from 3.49% to 1.15%. The average overall mortgage rate has sunk from 4.39% to 2.52%.
QE and the new TLS will aim to push down mortgage and loans costs. Banks have to balance lending and deposit rates and so may feel under pressure to reduce savings rates.
Some commentators have questioned how far banks and building societies can keep passing on rate cuts due to the balance because lower rates mean slimmer profit margins.
What else is affected by interest rates?
One of the most significant impacts of rate adjustments is on currencies. An anticipation of higher rates tends to drive a country’s currency higher while the prospect of a reduction will normally have the opposite affect. This is because a higher UK bank rate will attract foreign investors, pushing up demand for sterling-based assets and thereby supporting the currency.
Many other factors also influence currency fluctuations, including economic strength and political stability.
After the announcement today, the pound moved from €1.197 to €1.178 by 2.30pm.
* Based on implied forecasts from the Overnight Indexed Swap or OIS, taken at 1pm on 4 August 2016
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