British interest rates have been raised for what is, in effect, the first time in 11 years.
Bank Rate, the national benchmark, was lifted to 0.75% from a previous rate of 0.5%.
Mark Carney, Governor of the Bank of England, said; "Rates can be expected to rise gradually. Policy needs to walk, not run, to stand still.”
A key tool of economic management
A strengthening economy emboldened the Bank’s Monetary Policy Committee (MPC), the body that sets interest rates, to make what had been a widely-expected move yesterday.
Rates were slashed to 0.5% in March 2009 in the teeth of the financial crisis and Great Recession. This was an all-time low in the Bank’s 324-year history.
Although Mr Carney thus has, technically, raised rates during his time in office so far, this latest hike is generally regarded as his first “real” one.
For many people, interest rates are discussed principally in terms of mortgage costs and the rates charged on personal loans. But they are a key tool of economic management, one of the most powerful available to any government.
How do they work?
Higher rates usually sign of economic health
A good starting point would be to look at the MPC’s rationale for the move after the 2 August meeting. “Recent data appears to confirm that the dip in output in the first quarter was temporary,” it said, “with momentum recovering in the second quarter. The labour market has continued to tighten and unit labour cost growth has firmed.”
Higher rates work the opposite way, encouraging saving, discouraging debt and keeping a lid on inflation. They also tend to send the national currency higher, as overseas buyers seek the higher returns now available.
This makes imported goods cheaper, which may be some consolation to those whose spending power is now curbed by the higher rates.
The currency is the hinge connecting Britain with the world economy, so when UK factories and service industries are operating at full stretch during a boom, a rise in rates, pushes up the currency, and takes some of the pressure off British businesses by transferring some British consumer demand abroad.
Of course, the reverse is true when policymakers want to bring demand home again, through a weaker currency.
Thus, the Bank’s interest-rate decisions are transmitted to the wider economy.
Aside from economic management, the setting of Bank Rate is also an exercise in balancing different interests in society, the most important being the needs of borrowers and savers. Too low a rate would penalise savers, while too high a rate would make it impossible for people to take out mortgages and consumer loans and stifle enterprise by denying funding to businesses.
Until now, we have been looking at the operation of official interest rates in the textbook sense, the way they worked right up until the financial crisis of 2008. But as we saw at the start of this article, rates have been at all-time lows for nearly ten years, despite what would seem to be a buoyant economy, at least in terms of employment levels.
So, what has been going on?
The financial crisis took western economies into uncharted waters – uncharted since the war, at least. In official circles, the fear was that the Great Recession would turn into a re-run of the Great Depression of the Thirties.
It was imperative to keep people and businesses spending to avoid a major contraction of economic activity which, in turn, would have threatened deflation. This is especially damaging, as deflation reduces prices, thus earnings, but leaves debts with the same value.
Such debts become much more of a burden in relation to shrunken pay packets.
Interest rates stayed at rock-bottom levels despite strong signs of economic recovery.
Even now, Bank Rate is only 0.75%, a level unimaginable before 2008.
Return to normal?
In defence of low rates, the Bank would point to household income, which has remained historically very weak. In each of the five years 2009-2013, real, post-inflation earnings fell. They have struggled to recover since.
What happens next?
Opinion is divided. There are those who want to see a rapid “normalisation” of interest rates, fearing that the current ultra-low climate is encouraging the misallocation of resources in the economy. This include the keeping alive of “zombie” companies that ought to have been allowed to die and the over-supply of chain restaurants in British high streets, fuelled by cheap corporate borrowing.
The Bank seems to be seeking a middle path, looking for a “gently rising path” of interest rates. Whether it will be successful remains to be seen.