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Low interest rates – how much longer?


The UK has now experienced a 0.5 per cent Bank of England Base Rate for more than five years. Previously, in its over 300 year history, the bank’s headline rate had never fallen below two per cent. Clearly, we are in unprecedented times. It is worth going back those five and half years and reading again the Bank of England’s press release of 5 March 2009 to remind ourselves of the circumstances surrounding the decision to reduce rates to such a radically low level. The bank said then –


“World activity continued to weaken, reflecting both depressed confidence and the persistent problems in international credit markets. In the United Kingdom output dropped sharply in the fourth quarter of 2008. That reflected lower consumer spending, a further fall in business investment and a rapid run down in stocks, in part offset by stronger net exports as the past depreciation of Sterling began to take effect. Business surveys continued to point to a similar rate of contraction in the early part of this year. Unemployment has risen markedly. Credit conditions faced by companies and households remain tight… inflation is likely to fall below the two per cent target by the second half of the year… “


Economic conditions are now very different from those of March 2009. The markets are now betting on when the first increase in Bank Base Rate may occur with new Bank of England Governor Mark Carney’s “forward guidance” having, according to some commentators, not had the impact desired by the bank.


As we move towards an increase in rates of interest, it is interesting to reflect on the impact of both very low interest rates, and an increase in rates.


Of course, savers have been the principal group harmed by this policy with cash savings rates spending significant periods below the general rate of inflation and annuity rates falling to such an extent that even large lump sums generate small pensions. It is also conceivable that some savers have been induced by low rates on cash savings to take on more – possibly unfamiliar – risks in the search for yield. Conceivably this may have also led to the mis-pricing of such instruments.


In contrast, borrowers have been the main beneficiaries of this approach. Many existing borrowers have, in effect, experienced a sharp increase in their post-mortgage disposable income; new borrowers – especially homebuyers with a significant deposit – have been able to purchase houses at record low interest rates, and lock in these rates for five years.


By the second half of 2013 the beneficial impacts in the housing market (along with other housing policies such as Help to Buy) were reigniting a debate about the possibility of a housing bubble emerging, with the moral question of whether economic policy was harming prudent savers, while benefiting reckless borrowers, absorbing almost as many column inches.


Institutions stand in the middle of the transfer of resources implicit in low rates of interest – transfers generally from old people with savings to young borrowers in interest rate terms, and from young first time buyers to old last time sellers (or the middle-aged to older beneficiaries of their estates) in asset inflation terms.


The impact on institutions themselves has varied according to their business models. Many institutions offered rate guarantees, on at least some mortgages, linked to Base Rate – never envisaging that Bank Base Rate would fall to such a low level for such a long period – and thereby ensuring that their own income fell to a low level for a long period. All institutions have had to take into account the fact that the returns to be earned on liquidity fell so sharply that most institutions were making a loss on such holdings when the return was compared to the retail rates they were paying. Even very well run institutions found the overall impact to be a drag on their earnings. On the other hand, the “protection” provided to asset prices by low rates has surely meant that more institutions than would otherwise have been the case have survived the financial crisis – arrears and possessions have been much lower than in the early 1990s.


The arguments are now beginning to change. At the time of preparation of this article (the second week of September 2013), George Osborne, Chancellor of the Exchequer said that he was able to observe “tentative signs of a balanced, broad based and sustainable recovery” with independent agencies sharply increasing their estimates of UK economic growth.


The era of low interest rates could well be coming to an end. This will bring with it its own set of challenges, not least for unprepared borrowers – and unprepared arrears departments of lending institutions. However it could well lead to more appropriate returns to savers and improved margins for institutions. Moreover, rising interest rates should reflect stronger growth in output and incomes across the economy, which should help borrowers to adjust. However, the pace, and volatility, of interest rate changes will be very important. The Bank must continue to develop its new approaches to communication so that it helps to guide interest rate expectations to return gradually to more “normal” levels, while supporting the nascent recovery.


Sponsored by 24 www.bsa.org.uk


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