The primary goal of the Bank of England is to maintain monetary and financial stability. In the UK, interest rates are set by the Monetary Policy Committee (MPC), a division of the Bank of England.
It is tasked with keeping inflation low and stable with a secondary goal of supporting growth and employment. It is mandated by the Government to target an inflation rate of 2%. If inflation is significantly above this level, it is difficult for businesses and consumers to plan ahead. If it is significantly lower, consumers will delay purchases in the expectation of lower prices.
The primary tool for managing inflation is the Bank Rate, the interest rate which the Bank of England pays to commercial banks that deposit money with it. This influences the rates which commercial banks use to lend money out to borrowers and pay out to savers.
The interest rate reflects the interaction between savers and borrowers. Savers fund borrowers through the intermediary of a commercial bank. For the MPC, balancing demand from savers and borrowers is a challenge. If rates are too low, there is little incentive for savers to deposit funds. If they are too high, people will not borrow, potentially suppressing growth and employment.
Essentially the MPC’s role is to react to changing trends in the inflation outlook. If inflation is expected to be too high, it will raise interest rates in order to slow demand. Conversely, it will reduce them if inflation trends are weak and it needs to encourage demand. Quantitative Easing (QE), the creation of digital money used to buy corporate and government bonds, is another tool the MPC has employed in recent years in response to the financial crisis in a bid to stimulate inflation. This has increased the supply of money and kept yields suppressed by encouraging households and businesses to borrow money and also invest in financial assets.
Since the creation of the Bank of England in 1694, interest rates had never fallen below 2% until 2009. Rates were held at 0.5% from 2009 until 2016, even dropping to a historic low of 0.25% in the aftermath of the vote to leave the EU in 2016. Only since November 2017 have they started to increase. From a historical perspective, this period of inactivity may seem unusual. Closer examination proves this is not the case. Between April 1719 and June 1822 interest rates remained unchanged at 5%. George III may have reigned for 60 years, but he did not live long enough to experience a single interest rate move, an unthinkable phenomenon even in today’s world.
The 19th century was a far more volatile period. Financial panics were commonplace as a direct consequence of large credit expansions. The 1860s and 1870s saw an average of 10 rate moves a year with far greater volatility in terms of direction. 1866, for example, saw a total of 14 changes to the rate. Having started the year at 7%, it ended at 3.5%, peaking at 10% in May in the immediate aftermath of the financial panic which culminated in the collapse of Overend, Gurney and Company, a leading London wholesale bank. A full account of the events is available on the Bank of England’s webpage for readers interested in the story.
What stands out today is the extraordinarily low rate of interest when compared to the long run average of 6%, a level which also happens to be the original bank rate set in October 1694. We reached this situation as a consequence of the global financial crisis. With the economy now deemed to be in a stronger position, rates are finally on the way up, a process referred to as “normalisation” as they trend back to their long run average.
As discussed, low interest rates encourage spending and investment. Higher interest rates may have the opposite effect and slow the economy. However, if interest rates are too low for an extended period, they can promote a misallocation of resources and result in households and businesses becoming reliant on cheap credit. This can crowd out more dynamic businesses which are denied access to credit, eventually holding back progress and damaging overall productivity. Arguably this process has already taken place with interest rates at such a low level for such a long period of time. The poor underlying creditworthiness of a significant proportion of households and businesses may explain the slow and cautious approach from the MPC. Raising rates too quickly would create too much damage in the economy. Therefore we believe that rates are unlikely to rise back to the long term average of 6% for a long time to come. For the MPC, scaling back and ending QE would perhaps be a good start before embarking on significant interest rate hikes. The downside may be volatility in the corporate bond market, particularly at the lower quality end, where yields have been distorted by intervention.
The low interest rate environment highlights the importance of income within investment portfolios. Although interest rates are rising now, normalisation will take a long time, especially in the UK, and we expect interest rates to peak at a lower level than in previous cycles. Therefore it is essential to focus on varied sources of income across different asset classes such as equities, bonds, property and other alternatives. Investing in quality assets means that whatever direction rates move in, income will be secure over the long term.