MPC leave interest rates unchanged - InterestRate.co.uk

MPC leave interest rates unchanged

In a week when the fragile nature of Brexit was exposed, it was welcoming to see the Bank of England Monetary Policy Committee (MPC) announce unchanged UK base rates. Rates currently stand at 0.1% although there had been speculation of a dip into negative territory in the short-term. The MPC minutes cover a range of different subjects, giving insight into the UK’s immediate economic prospects.

Prospects for the UK economy

The conclusion is simple; short-term pain will likely be replaced by a medium to long-term increase in economic activity.

While initial indicators at the beginning of 2021 suggested an 11% GDP reduction in 2020, these figures have been revised. While still a significant drop, GDP for the whole of 2020 was down by 10%. Some experts had been predicting an even more substantial reduction once all data was available. As a consequence, the UK has avoided the dreaded “double-dip” recession.

Before the lockdown in late 2020, the MPC November report suggested an increase in GDP in the first quarter of 2021. As a consequence of more challenging COVID variants, and further lockdown restrictions, GDP is expected to fall by around 4% during this period. Overall, the Bank of England believes GDP will increase by 5% in 2021, down on the previous prediction of 7.25%. Encouragingly, expectations for growth in 2022 have been revised upwards, from 6.25% to 7.25%.

The November MPC report was tentatively forecasting an increase in first-quarter 2021 GDP. The latest revisions perfectly highlight the extreme volatility and fickle nature of even short-term forecasts in the current climate.

Outlook for UK base rates

The outlook for UK base rates was covered in significant detail by the MPC announcement today. While initially, money markets seemed to suggest we are at the bottom of the interest rate cycle, Bank of England governor Andrew Bailey issued an interesting statement:

“My message to the markets is: you really should not try to read the future behaviour of the MPC from these decisions and these actions we’re taking on the toolbox.”

So, while there is hope that the UK economy has turned the corner, base rates remain unchanged at 0.1%, the Bank of England still reserves the right to use all tools in the toolbox. However, there are several challenges when it comes to reducing base rates below 0%.

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Preparation for sub-zero base rate landscape

When initially floating the idea of sub-zero base rates in 2020, the Bank of England began an in-depth consultation with the financial industry. There are certain obvious implications, as well as numerous knock-on effects if base rates were to move below zero:

  • Banks could decide to charge savers for holding their funds (more likely they would revert to a 0% savings rate and increase banking charges).
  • In theory, lenders would slash credit card and personal loan interest rates – but they would still be in positive territory.
  • Interest rate tracker mortgages would become more attractive, but the small print would likely limit the downside, certainly not below 0%
  • Businesses would be encouraged to borrow and invest, on minimal interest rates, thereby increasing economic activity.
  • Consumers would be encouraged to borrow and spend – although the MPC would need to monitor the impact on inflation.
  • This move would see a raft of refinancing by consumers and businesses, paying off existing higher interest rate debt.
  • UK banks and lenders would not encourage a free for all. Instead, they would likely tighten their criteria for loan and mortgage eligibility.

In reality, where lending and borrowing are involved, there would be at least some impact if UK interest rates moved into negative territory. However, those hoping that loan and mortgage rates would dip into negative territory are likely to be disappointed.

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Interestingly, the Bank of England issued a formal statement regarding the potential implementation of this policy:

“The Prudential Regulation Authority’s engagement with regulated firms had indicated that implementation of a negative Bank Rate over a shorter timeframe than six months would attract increased operational risks…”

Therefore, it is safe to assume that UK base rates are unlikely (although not impossible) to fall below 0% over the next six months. Even though the financial industry is primed for the potentially unthinkable, it would take up to 6 months to adjust the current framework and practicalities. Has the spectre of negative base rates been removed forever or just delayed?

Unemployment in the UK

All eyes will be on the rate of unemployment in the UK over the coming months. The most recent report from November cited a rate of 5%, which is partially shielded by the ongoing furlough scheme. The MPC believes that the unemployment rate will increase to 7.8% later in 2021, as the furlough scheme finally comes to a close.

On the upside, as the furlough scheme winds down, the UK economy will start to wind up. So the potential increase in unemployment will be reduced somewhat by an expected increase in economic activity. To what level remains to be seen but the Bank of England has maintained its current stance, an expected peak in unemployment later this year.

There are numerous caveats in the MPC statement, one of which suggests that the UK’s economic outlook still remains “unusually uncertain.” This is to be expected in these times, the likes of which we have never seen before. However, there is a cautiously optimistic thread to the overall MPC statement today.

Inflation set to rise as the economic outlook improves

Inflation has been relatively subdued in recent months, as a consequence of reduced economic activity. The 12-month Consumer Price Index (CPI) inflation figure increased from 0.3% in November to 0.6% in December. While this is well below the Bank of England’s target rate of 2%, the MPC expressed expectations of a significant increase towards the spring of 2021. Inflation is not expected to exceed the Bank of England’s 2% target over the next three years.

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As base rates are used as a basic tool to control inflation, this would suggest the chances of interest rate reductions over this period are minimal. In the short-term, inflation will be impacted by the removal of various VAT reduction schemes and household/business subsidies. While a jump from 0.6% inflation up to 2% may seem significant, the broader consequences are more positive for the economy. An increase in inflation allows businesses to increase the cost of goods/services, thereby feeding wage increases, which will filter through into increased consumer spending.

It was interesting to see that the Bank of England MPC also mentioned consumer confidence. While financial support and indications of better times ahead are welcome, it is the so-far hugely successful vaccination rollout, which is improving consumer confidence.

Improving prospects against a fragile economy

It is safe to say that this week’s MPC report is one of the more positive we have seen in recent times. While short-term caveats remain, such as the vaccination programme‘s success and future emergence of new COVID variants, there are tentative signs we may be over the worst. Even though the UK government has borrowed huge amounts of money to support businesses, and these borrowings will need to be serviced and eventually repaid, we are currently in a historic low interest rate environment.

The road to a full recovery is likely to be long and winding, and we should still expect bumps along the way. However, tentatively, even previous pessimists are starting to reconsider their positions.

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