In the face of a recession, a central bank's main weapon in combating a fall in the country’s economic output is to cut interest rates. By doing so, the costs for business and individuals to borrow from commercial banks falls. This, in theory, should then boost demand in the economy through consumption and investment.
This is exactly what happened when interest rates set by the Bank of England fell from 5% in April 2008 to 0.5% in March 2009 in the wake of the financial crisis. Rates stayed at historically low levels until last year, when the group in charge of setting rates, the Monetary Policy Committee (MPC), reduced the rate to 0.25%, following the European Union referendum last year.
It’s generally hard to quantify the effect of these interest rate cuts, but the loose monetary policy since 2008 would have had a net benefit on the British economy’s post financial crisis recovery.
It is expected that the transmission mechanism for feeding base rate interest rate changes into the economy can take up to two years to take effect. Even so, the Britain's economic recovery cannot be put down solely to the monetary policy enacted by Mervyn King and Mark Carney. Indeed, the British economy nearly stagnated into recession in 2012, despite the rate remaining at 0.5%.
Brexit is providing difficult headwinds for the economy. The pound is still 12% down against the dollar, causing inflation to reach 3%. Consequently, real incomes are at a negative. The savings ratio of many consumers has fallen further and consumer debt is reaching ever higher levels. Here is why this may spell trouble for Mr Carney.
A devaluation in the pound can often take place naturally, as the foreign exchange market takes into account a variety of factors, such as demand for the currency, interest rates, and political turmoil. The issue with the devaluation experienced after Brexit is that it was so rapid. This gives businesses that buy goods in dollars no time to adjust to the increase in price, so business uncertainty increases.
Consumers face an entirely different struggle. The pound in their pocket is buying them fewer goods. Food prices have increased by an average of £21.31 for quarterly bills. This will therefore reduce disposable income, which would have been spent in other areas of the economy.
In periods of low disposable income, cheap credit, facilitated by the central bank’s low interest rates, can pick up the slack. Low repayment costs can allow families to enjoy now and pay later.
However, a darker storm is approaching.
These loans are performing well for banks at the moment, but there is no certainty that this trend will continue into the future. A poor Brexit deal, including no deal, has the potential to tip the economy into recession. This, accompanied with inevitable job losses, could soon turn dubiously performing loans into non-performing loans, sending the banks down under again.
In the event that this does happen, how would the MPC react? Assuming that rates are at 0.25%, would a fall to 0% make an effect? There is very little room to manoeuvre if this does happen.
The Eurozone had a much harder recovery following the financial crisis. Consequently, the monetary policy implemented by the European Central Bank (ECB) was much looser than that of the Bank of England.
On the 11th of July 2012 Mario Draghi and the governing council of the ECB voted for interest rates to be lowered to 0%. Since 2012 rates have fallen even further, and in March last year interest rates fell to -0.40% , meaning that it effectively costs money to deposit money into a bank account.
The idea behind this is that if it costs money to deposit, then consumers will money rather than leave it dormant in a bank account. Therefore, the spent money will end up revitalising the economy, or so the theory goes.
Is another rise inevitable?
Some members of the monetary policy committee have started to vote for interest rate rises.
On the 15th of June, Kristin Forbes, Ian McCafferty, and Michael Saunders, all voted to increase rates to 0.5% but were ultimately outvoted. Gradually, more members of the MPC are changing their attitudes, so a base rate rise looks likely in the future.
In Britain, with inflation overshooting the 2% target, and an uncertain economic forecast, a change in interest rates may be necessary.