3.1.2 Have borrowers never had it so good?
In the following video, Andy Haldane, chief economist of the Bank of England, talks to Martin about the trends in borrowing in the UK during the current period of low interest rates and whether these trends are of concern to the Bank.
Those borrowing money in recent years have benefited from the historically low rates of interest charged on debt products. Why have interest rates been so low since the end of the 2000s? To understand this, we need to explore how the ‘official’ rate of interest is set in the UK, since this provides the basis on which interest rates on financial services products are set.
As we saw in Week 2, responsibility for monetary policy was passed from the UK government to the Bank of England in 1997. This enables the Bank to set the level of the UK’s official interest rate without being subject to political influence. This matches the arrangement in the US and in the eurozone, where the official rates are set by the Federal Reserve Bank and the European Central Bank respectively.
The rate set by the Bank’s Monetary Policy Committee (MPC) – Bank Rate – is the rate at which the Bank of England will lend to the financial institutions. This, in turn, determines the level of bank ‘base rates’ – the minimum level at which the banks will normally lend money. Consequently, Bank Rate effectively sets the general level of interest rates for the economy as a whole. Bank Rate is therefore hugely influential in the determination of the rate that will be paid on savings and interest-bearing investment products.
The prime objective is for the MPC to set interest rates at a level consistent with inflation of 2 per cent per annum (p.a.). For example, if the MPC believes inflation will go above 2 per cent p.a., it might increase interest rates in order to discourage people from taking on debt – because if people spend less, it could reduce the upward pressure on prices. Conversely, if the MPC believes inflation will be much below 2 per cent p.a. it might lower interest rates (also known as ‘easing monetary policy’) – people might then borrow and spend more.
Given the weakness of the economy after the financial crisis, Bank Rate was cut to a historic low of 0.5 per cent in March 2009 to help stabilise the financial system and foster economic activity. The rate remained at this level until August 2016 when it was cut further to 0.25% to help confidence in the economy after the vote to leave the European Union (Brexit) in the June 2016 referendum.
With unemployment falling quickly after 2012 and with stronger economic activity generally, the governor of the Bank of England, Mark Carney, regularly indicated that Bank Rate was likely to rise (gradually) in the not too distant future to prevent inflationary pressures building. Eventually in November 2017 the MPC raised Bank Rate to 0.5% – the first increase for ten years.
Despite falling unemployment, the absence of material price inflation pressure and the uncertainties about the prospects for the UK economy once Brexit occurs have provided a strong argument to hold off from tightening monetary policy materially. This is continued good news for borrowers although, as Andy Haldane comments in the video, the growth in certain forms of personal borrowing – partly stimulated by the prevailing low interest rates – is a matter of concern.
Official rates of interest tend to be cyclical, rising to peaks and then falling to troughs. Since 1989, the trend in the UK has been for nominal interest rates to peak at successively lower levels. Nominal rates fell to 3.5 per cent in 2003. In 2009 they hit a record low of 0.5 per cent.
Note that real interest rates are nominal rates adjusted for the prevailing rate of price inflation. So, for example, if the nominal rate of interest is 2 per cent and price inflation is 2 per cent, the real interest rate would be 0 per cent (zero).