The shock vote to leave the European Union sparked volatility across financial markets and on 14 July the Bank of England added a further surprise when it decided to keep the base interest rate the same.
Interest rates set by the Monetary Policy Committee have been unchanged at 0.5% for over seven years now. Many anticipated that the Bank of England would look to lower interest rates by 0.25% to combat the initial negative impact of BREXIT, particularly given that the governor, Mark Carney, said that the central bank would look to introduce further easing soon to help address the slower than expected growth of the UK economy.
In the past there have been significant benefits to swift action from a central bank when faced with certain upcoming economic risks. When in role as the Canadian Central Banker, Carney won international recognition by acting ahead of the 2008 financial crisis. Monetary easing measures were introduced prior to the recession and this helped the Canadian economy to move through the global recession relatively unharmed. Investors and economists around the world expected him to repeat this in the UK, ahead of the seemingly inevitable post-BREXIT recession.
But the 2008 financial crisis and the UK leaving the EU are very different events and taking the same interest rate cutting strategy could have a different outcome. There could be better policy measures that address the liquidity and credit concerns at a time of political uncertainty.
Cutting interest rates may not work this time
Economic theory states that a central bank can stimulate an economy by cutting the base interest rate. In theory this encourages businesses to borrow from banks to expand and make further investment, the average household should also be encouraged to spend and invest providing a further boost to the economy. But when interest rates have been historically low since 2008 and we face a heightened level of economic and social uncertainty it is unlikely that a cut in interest rates would deliver the expected results.
A cut in interest rates at this time could have an adverse effect. The banks already face a slim net interest margin (lending rate to deposit rate) and this would be cut even further which in turn would discourage banks from lending more to both business and individuals. A company with a defined-benefit pension plan would suffer as there would be an increase in pension liabilities which would limit their ability to invest in new areas and expand. Individuals saving for their future would also suffer, particularly those either approaching or already in retirement. A cut in interest rates could mean they need to save more to fund their retirement.
A more informed decision
Another consideration for the Bank of England is the impact of a rate cut on the performance of sterling. Since the referendum result the value of the pound has dropped by more than 10% and reached multi-decade lows in terms of value against the US Dollar.
Following the comments from Carney the value dropped even lower as markets anticipated a cut in interest rates last week. The rally in sterling at the end of the last week was partly due to the correction in the market. A further cut in interest rates could see the value of sterling fall even lower.
Whilst there are benefits of a lower pound to some parts of the economy (export led businesses) there is also a risk to financial and economic stability from a sharp currency depreciation. A weakening of sterling could lead to high inflation, which would threaten ‘real’ household income, wealth and economic growth.
A delay in the decision to cut interest rates at this point shows prudence from the Bank of England. We are still waiting for clarity on the true economic impact of the vote to leave. Some of the key economic data will not be available until early August, indicators such as the Purchasing Manager Index.
A month on from the EU referendum global markets have moved on from the shock following the result. We are seeing positive job figures in the US and a steady recovery in emerging markets. The UK has formed a new government and are looking to start the exit negotiations with the EU sooner than initially anticipated. We are likely to see the Bank of England work closely with the new government to use the range of instruments at their disposal in order to avoid causing further speculation and market volatility.
