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What will happen when the Bank of England hikes interest rates?

It’s the hint economic pundits have been waiting for; the Bank of England is flirting with a return to normal monetary policy and could hike interest rates within months.

Headed up by Mark Carney, The Bank of England has been under pressure to increase the bank rate this year, in response to inflation that remains stubbornly above its 2% target.

It was inflation’s oil and weak sterling-induced bounce back to 2.9% that forced the Bank of England’s hand this week, as Carney warned that the MPC could start withdrawing its monetary stimulus “over the coming months”.

Market expectations for a rate hike before February – when the current programme of monetary policy runs out – jumped from 37% to 60%, and sterling rallied to a 15-month high – good news for those managing to get away for a cheap late-summer holiday as the kids return to school.   

How is the UK economy doing?

As I delve back into my old economic books and theory states that economists should be tightening monetary policy on the back of increased inflationary pressures and a reduction in slack.

But wider measures of economic health in the UK are more contradictory – it’s certainly not an easy time to raise rates. 

UK economic growth has slowed, with growth of 0.3% meeting expectations but still relatively weak compared to the rest of the G8.

Unemployment inched to a 40-year low of 4.3% in August, but wage growth of 2.1% is below expectations and still being outstripped by inflation.

Consumer price inflation is now expected to overshoot the Bank of England’s 2% target for the next three years, and is forecast to reach 3% year-on-year in October.

An increase in wages – perhaps led by public sector pay increases – could be just the trigger Mark Carney is waiting for to start normalising interest rates.  

What is UK monetary policy?

The MPC aims to keep UK inflation close to its 2% target, by manipulating interest rates and quantitative easing.  

After the UK voted to leave the European Union, the Bank of England decided to halve the bank rate to 0.25% and extend its quantitative easing government bond buying programme to £435 billion over the following 18 months. It’s also buying £10 billion of corporate bonds.

This package of monetary policy stimulus will run out in February 2018, if the MPC doesn’t decide to do it before.

What does it mean for your money?

A hike in the bank rate will finally give Brits some respite from the harsh savings environment that has stifled the returns on cash accounts for nearly a decade. As the bank rate sits at 0.25%, the best returns you can expect on an easy access cash ISA is just over 1%, which means inflation of 2.9% is eating into the purchasing power of your hard-earned savings.

A 25 basis point increase in the bank rate won’t magic away the difficult savings environment and high street banks might not reflect these changes in the immediate future. But any change to the saving environment acts to remind us of the alternative options available to us.

But interest rates aren’t just about saving, as savers breathe a sigh of relief, borrowers will grimace. Many consumers have turned to cheap borrowing to cope with the consumer squeeze – consumer credit jumped 10.3% in the year to May 20171, with car financing making up the bulk of this.

When the bank rate rises, so will the interest Brits have to pay on their loans, which could be tough for borrowers who haven’t prepared. More expensive debt will force many to either reduce their spending or default on their loans; neither of these options are particularly good for the economy overall.

Good news for sterling

A hike in interest rates will be good news for sterling, though, which has been feeling the pressure after last summer’s Brexit vote.

It might be tempting to wholly focus on the UK if sterling continues to strengthen, but this could do more harm than good. Global exposure may weigh on your returns in the short-term, but this diversified approach would have supported investors during the post-Brexit fall out. Savvy investors use diversification to meet their long-term financial goals.

1 How Britons are racking up personal debt, Financial Times, June 30.

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