Bank raises interest rates to 2.25%

Categories: Salford Business School

As the Bank of England raises rates for the seventh time in a row, to 2.25%, Dr Tony Syme, finance and economy expert from the University of Salford gives his take on what might happen next.

Dr Syme said: “Another month, another interest rate rise, but now with a quickening pace. And the Bank of England is not alone in this. Yesterday, the US Federal Reserve announced that it was raising its key rate by three-quarters of a percentage point and that only mirrors the same rise announced by the European Central Bank earlier this month.

“The big question is how far will interest rates rise. There are two things to consider. The first is that interest rates are almost always above the rate of inflation. Apart from the years of very high inflation in the 1970s, the Bank of England’s Bank Rate has always been above the inflation rate for the last 70 years.

“If inflation is greater than the rate of interest, any returns from lending money are more than wiped out by the fall in the value of money, so there is no incentive to lend. A positive ‘real interest rate’ is needed to ensure the market’s supply of loanable funds.

“A higher interest rate also enables monetary policy to be ‘active’. When the Bank Rate was lowered to 0.5% in March 2005, the Bank of England faced the ‘zero lower bound’ problem. Interest rates could hardly be lowered any further, so it had to turn to more unconventional monetary policy measures such as quantitative easing. The Bank of England didn’t change interest rates again until August 2016.

“The second thing to consider is the relationship between the Bank of England and the Federal Reserve, or at least between their two currencies. With the dollar as the key international currency, it has been viewed as the most stable currency in the world economy. The risk premium is near zero and lower than for other currencies. To offset that risk premium when buying financial assets in sterling, investors need a higher return of their investments in sterling and so interest rates are generally higher in the UK than in the US. That risk premium will only increase with the large increase in government borrowing to be announced in tomorrow’s mini-budget.

“Since the start of the 1990s, the rate set by the Bank of England has always been higher than the rate set by the Federal Reserve which two short exceptions: May-December 2000 and March-December 2006. At their peak, interest rates were 0.75 percentage points higher in the UK than in the US, while in the other periods, interest rates were up to 7 percentage points higher in the UK than in the US.

“All this pre-dates the Financial Crisis of 2008-09 and this was the era of stable, conventional monetary policy to which both central banks would like to return. In this period, the Bank of England generally set its interest rate two percentage points higher than expected inflation rate and around one percentage point higher than the Federal Reserve.

“With an inflation target of two percent, this suggests that we should expect to see interest rates rise to at least 4 percent and not be lowered again. If government borrowing continues to rise, that interest rate will rise even further due to the increased risk premium and if the Federal Reserve continues to raise interest rates, then we should expect the same in the UK.

“One thing is clear. The era of cheap interest rates and unconventional monetary policy is over. We can expect interest rates to be in the 4-5 percent range even in good economic times.”

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