Following the recession in 2008 UK interest rates were cut to try and boost the economic growth for the country. According to Fender, (2012), lowering of interest rates in an economy has several effects to the economy of the country concerned and this is why the British Central Bank lowered the interest rates hoping for positive effects to the economy. As expected, the action by the central bank has resulted in some economic impacts to the economy of the country (Pettinger). In theory, lowering the interest rates, Ceteri Paribas, results in higher economic growth levels. However, there are other economic factors that come into play, and the result of a lowered interest rate is not straightforward (Baye). The following sections of the report will discuss both microeconomic and macroeconomic effects of low interest rates in the UK and also anticipate what can be expected from the Central Bank of England.
Reduced Incentive to Save
Investors mainly save to earn higher interests on their savings. However, with low interest rates offered by banks in Britain, it has become increasingly less attractive for investors to save their surplus disposable income (Pettinger). Consumers, therefore, prefer to invest their surplus income on tangible assets or on other forms of expenditure that are not necessarily an investment in nature. At high interest rates, consumers save more with the expectation of earning more interest from their savings in the long run. The interest rate in Britain has mostly been at 0.5% which is low and offers very low returns on savings (Pettinger).
Cheap Borrowing Costs
When the Bank of England lowered the interest rates, it effectively lowered cost of borrowing money from financial institutions. The interest charged on the money lent to consumers is low and thus encourages more consumers to borrow more and spend more (Bean). Big organizations in the country have also been able to borrow money at low interest rates and hence been able to invest more and expand their operations. As such, over the last seven years, businesses in Britain have been able to expand their operations and experienced growth. This is especially the case considering that consumers have had more to spend, thereby pushing the demand up, hence the need for expansion of businesses to meet the increased demand (Bank).
Low Interest Payments on Mortgages
The low interest rates in the UK over that last seven years has resulted into more homeowners due to the low interests charged on mortgages (Jones, White, and Dunse). Before the 2008 recession, it could have been difficult for a majority of UK middle-class consumers to afford their homes. However, with the reduced to almost zero interest rates, it has become affordable to pay mortgages and own homes. Further, investors can acquire real estates through mortgages and keep them for sale in the future when the prices go up (Jones, White, and Dunse). The low interest rates have allowed investors to borrow loans and acquire real estates, replenish them and sell them at inflated prices. Once the consumers have bought their homes through mortgages, they remain with more disposable income which they can spend in the economy. Even the low interest payments, leaves them extra disposable income to spend in the economy and hence, increase the money supply in the economy (Newbold, Carlson, and Thorne).
Rising Asset Prices
The low interest rates in Britain makes it attractive to buy assets that appreciate in value as time goes by such as housing (Jones, White, and Dunse). Consequently, the demand for such assets goes up and through the forces of demand and supply, the prices of such assets rises. The rise in asset prices leads to increased wealth in the hands of those who have the assets. Increased wealth encourages consumers’ spending since the level of confidence is higher. This effect is referred to as the wealth effect. There was a sharp decline in wealth in the UK during the 2008 recession. According to Pettinger, (2009), the decline amounted to £844 billion or an equivalent of 13% decline in British wealth. The decline, he says, was a sum of £394 billion declines in housing wealth and another £450 billion fall in other forms of assets (Pettinger). However, from 2009 onwards when the low interest rates were introduced, asset prices have stabilized, and housing has particularly become more highly valued.
The level of wealth in an economy has considerable impact in swaying consumer spending habits. For instance, when the prices of housing rises, it boosts consumer spending because;
House owners are more confident to spend. The rate of saving through the banks mostly fall as house owners regard housing equity as being a form of saving that earns higher interest for them (Pettinger).
Withdrawal of Equity. When the prices of houses rise, it allows house owners the opportunity to re-mortgage the houses. This avails more money in their hands to spend in the economy (Baye).
It is important to note, however, from the preceding, changes in wealth will not always have a direct impact on consumer spending. A majority of the households in the UK do not affiliate their spending to their house values (Jones, White, and Dunse). This is because, even if the prices of the houses rise, they normally can’t access it unless they re-mortgage their house. Re-mortgaging in Britain is done by a few and not the majority of house owners (Pettinger).
Exchange Rate Depreciation
The low interest rates in the UK of as low as 0.05% makes it comparatively difficult and less attractive to save money in Britain (Wright). As has been mentioned earlier, such savings would earn meager interest and therefore, individuals and corporations opt to save money in another country. As a result, the demand for the sterling pound falls and consequently the value falls as well. This has been the case with the currency as a result of the low interest rates. The depreciation of the sterling pound has made exports from Britain more attractive and competitive both in the European market and the international market (Bank). However, it also makes imports to the UK more expensive as compared to before. The prices of imports in Britain has since risen in the last seven years. This depreciation in Pound Sterling helps increase the aggregate demand for goods and services as demonstrated below.
Expectation from the Central Bank of England
In 2015, the governor of the Central Bank of England announced that the interest rates would be increased in 2016 following the stabilization of the economy. However, later on, the bank stated that the current interest rate level of 0.5% which is the lowest in the recorded history of the country will continue for some time until probably the end of 2016. While announcing the plan to have the rate continue, the governor, Mark Caney, cited some reasons for the decision. First, he cited the uncertainty that exists about the growth of the global economy. Secondly, he noted that the forecast for inflation indicated that it was expected to remain low for longer (Sentance). The reasons given by the central bank coupled with the eminent referendum on the status of Britain in the European Union implies that we can expect the Central Bank of England to at least leave the interest rates at low levels for a little longer to avoid destabilizing the economy at a crucial moment (Sentance).
Conclusion
The effect of low interest rates has been numerous in the British economy. The central bank's Monetary Policy Committee has been monitoring the rates on a monthly basis to ensure that inflation in the country does not go above or below the 2% target that has been set (Giudice, Kuenzel, and Springbett). However, in 2009 when the low interest rates were introduced, they were intended to be short-term measures that would help in the recovery of the economy as more long-term solutions were looked into. Seven years down the line, the country is still using a monetary policy that was intended to last for only a short while (Wu). The effect of the low rates especially on the saving culture of the country’s young generation may hurt it in future. At the rate of 0.5%, there is no incentive to save and thus, the young generation growing now, may not adopt the culture of saving even when the situation improves in future(Giudice, Kuenzel, and Springbett). This is because they have not been introduced to the culture early enough. It is important for the Bank of England to come up with a long-term monetary policy that will encourage both spend and more importantly saving. Low interest rates are good for the economy in the short run but less favorable in the long run.
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