At 12pm today the Bank of England (BofE) Monetary Policy Committee voted 9-0 to cut the UK base interest rate to 0.25% from 0.50%. The GBP/USD reacted sharply falling 1% to 1.3130, and the FTSE100 gained 1.6% to 6,727.
Prior to the release of the decision the markets remained flat, with the GBP/USD even testing a rally as high as 1.3300. The FTSE100 remained flat because the market had already priced in a rate cut – with 98% of polled economists in agreement.
However the Bank went a few steps further and introduced additional stimulus plans.
- 25bps base rate
- Additional £60bn asset purchasing program
- Asset purchasing expanded to corporate bonds
- Strong suggestion in minutes that MPC members expect 0.00% base rate by 4Q16
Why does the FTSE100 rise?
A base rate cut reduces yields on bonds, encouraging investors to move their money to higher yielding equity. Furthermore the BofE’s decision to purchase corporate bonds and increase asset purchasing raises the amount of liquidity (cash) in the system, which encourages spending. This is combined with a lower base rate also reducing the interest rate on mortgages and credit goods, which likewise boosts the UK economy and thus business profits.
Why does the GBP/USD drop?
Lower interest rates reduces the yield on UK assets (think savings accounts) and signals the economy is not strong at the moment. As a result foreign investors decide not to invest in the UK, reducing demand for GBP – increasing its supply and decreasing its price.
This move was anticipated but is a stark change in the direction the Monetary Policy Committee, who had suggested earlier in the year that the base rate would rise. This decision tells us that UK monetary policymakers are willing to induce inflation in order to boost the economy and stabilise the markets, two issues that have come as a result from the UK referendum on Brexit. With a 9-0 vote we can expect monetary policy to remain loose for the foreseeable future.