When the Bank of England raises interest rates, or more technically the base rate, we will see a ripple effect through the economy. This effect is important! It helps explain why interest rates were reduced in the first place and what might happen to your personal finances.
How does the Bank of England raise interest rates?
The Bank of England (BofE) has a monopoly supplying base money. That is notes, coins and also banker’s deposits at the central bank. Therefore by changing the price of base money, the base rate, they cause a series of events to occur through the economy and financial markets.
What is the ripple effect?
The economist term for this is the Transmission Mechanism (Fig.1). This mechanism demonstrates in a concise manner how an increase in the base rate will filter through the economy. The ultimate aim for the BofE is to affect inflation. They are targeting 2 per cent inflation asymmetrically, therefore 1 per cent is just as bad as 3 per cent.
- Market rates. The base rate increases, immediately affecting the cost of banks to lend from the central bank. They pass this rate onto us in the form of higher interest rates on mortgages, savings accounts, loans etc. This decreases demand for credit goods in the economy (e.g. cars), reducing overall demand and dampening inflation.
- Asset prices. Ioannidis and Kontikondas proved that the base rate is linked to the discount rate of shares. When the base rate increases the discount rate also rises and the present value of future cash flows for a company decreases. Because the value of a company is intrinsically linked to the value of its future cash flows, share prices will fall. This may be magnified as investors seeking safer yields might also move their funds from stocks to bank savings, which are now providing a higher return. Bond prices also fall as newer bonds issued, with higher interest rates, become more desirable.
- Expectations. This has become an increasingly important part of the mechanism. By raising interest rates the BofE is signalling to the markets that there are inflationary pressures, which indicate strong growth in the UK. This is a boost of confidence for the markets, resulting in higher economic activity.
- Exchange rate. When the interest rate in the UK rises foreign investors begin to invest their money in UK accounts, which are now yielding a relatively higher yield than their domestic economies. As a result the demand of sterling increases and therefore so does its price. Higher sterling = cheaper imports = lower inflation.
This mechanism does have a drawback though, it can take up to a year for the effects to filter through the system. Therefore when Mark Carney decides on interest rate policy he is looking at potential inflation figures in the medium to long term. This is why current discussions on a rate increase are happening, even though UK inflation is historically very low and near deflationary at 0%!