Interest rates refer to the cost of credit or debt capital computed as annual percentage ratio (APR) interest to the principal. Lower interest rates are set with the aim of spurring an economy out of recession. Although low interest rates encourage businesses and consumers to borrow and buy more which tends to put money into circulation as well as increases money supply hence providing a leverage for economic recovery, it can also lead the economy and businesses into recession if it carries on for too long.
This report will look at some of the consequences of low interest rates on the United Kingdom, a G7 developed economy. The Group of Seven (G7) are the world’s largest industrialized countries made up of the United States, Canada, France, Germany, Italy, Japan, and the United Kingdom that meet periodically to discuss issues such as global economic governance, international security, and energy policy (Laub and McBride, 2015). In the United Kingdom, it is the duty of the MPC (Monetary Policy Committee) to meet every month to set rates. The MPC is made of nine members: the governor, two deputy governors, the Bank’s chief economist, the executive director for markets and four external members appointed directly by the chancellor. (BBC Business News, 2011). On the 15th of December, 2016, the MPC on behalf of the Bank of England, voted unanimously to hold the interest rate of the country at a base rate of 0.25% in order to meet the 2 percent inflation target in order to help sustain growth and employment (Trading Economics, 2016). With the interest being held at its lowest in the 300-year history of the nation, what is its effect on the economic system, housing, businesses, its citizens and employment?
CITIZENS
As stated above, low interest rates revive an economy to some extent, but after a while its citizens and business begin to writhe from its impact. Larry Fink, the boss of fund manager BlackRock captures this in a comment:
“A 35 year-old looking to generate an income of £35,000 per year for retirement beginning at age 65 would need to invest £125,000 in a 5 per cent interest rate environment but in today’s 2 per cent interest rate environment, that individual would need to invest £400,000 (3.2 times as much) to achieve the same outcome when they stop working” (Andreas Whittam Smith, 2016).
This is the reality that investors who have to buy their own pensions face too. In furtherance, Moneyfacts, a data firm states that, in the late 1990s, £100,000 would have bought a 65-year-old Brit a lifelong income of £11,170 a year; now it will earn only £4,960. The implications of this is that employers and workers need to put more money aside for retirement as the above analysis indicate a rise in the cost of paying pensions because of the obdurate low level of interest and bond rates (The Economist, 2016).
ECONOMY
Consumers see low rates as a disincentive to save since it yields lower returns and therefore hold onto their money. Holding onto money as opposed to saving it, would result normally to spending it, paying off debt or investment. When spent on goods and services, it causes an increase in demand in the economy causing the driving forces of demand and supply to determine a higher equilibrium price. Since consumers do not save due to the unattractive interest rates on their savings and certificates of deposit, the banks lose deposits. Similarly, low interest rates affect the price of insurance premiums because insurance companies rely on interest-based return on the money they receive in premiums to support their coverage liabilities hence do not get much due to lowered rates. Low interest rates also negatively affect people who live off the interest income from their savings making them cut back on their spending (Bank of England, 2016). It be stated that, low interest rates can also have a positive effect on the economy as it can increase the prices of assets such as houses and shares. This in turn enables existing home owners to re-mortgage their houses in order to finance higher spending. In addition, higher share prices raise households’ wealth and can increase their willingness to spend.
BUSINESSES
Businesses see low rates as an opportunity to secure capital resources for business growth and expansion. However, with investment into mortgage, banks would rather take the opposite stance by withdrawing or moving initial deposits up knowing that they stand to lose with low rates as it does not represent a viable business initiative to trade in (Pettinger, 2013). This is because when interest rates are unusually low, the banks deposit base falls too since people would rather spend or invest than save, therefore they only loan to borrowers with high credit ratings and substantial assets to serve as collaterals for their loans as the income from loans is not encouraging enough to take risks. Similarly, it becomes difficult for citizens to finance small business operations as they cannot get a substantial loan from the bank to help them keep their business afloat. Its follow-on effect might be to have to lay off some employees, to reduce expenses as business slows down is a carry-on effect from the customers not being able to borrow hence they have no money to spend.
EMPLOYMENT
As hinted above, the consequence of low interest rate is the likelihood of high unemployment in the country as there is a reduced flow of money in the economy and instead investments in assets such as the stock market and paying off debts which do not produce employment. This then means that, its citizens are cash-strapped and companies would have to start laying off expensive workers in exchange for temporary or part-time workers at lower prices. The spiralling effect would be low wages, followed by less spending hence prices on goods and services are forced down, leading to more unemployment, lower wages and the cycles goes on and on. Although, according to the Financial Times, Britain’s unemployment rate has stayed at an 11-year low with the jobless rate holding steady at 4.9 per cent in the three months to the end of July (Khan, 2016).
HOUSING
Housing in the UK is mostly privately owned and occupied houses and apartments, privately rented and local authority rented accommodation or property managed by estate agents and housing associations. Changes in interest rates, according to (Economics Online, 2012), impacts consumer spending power and on the house market especially due to the large number of home owners in the country. Although house values went up by an annual 4.5 percent in the UK, London’s housing market underperformed when compared to the rest of the nation for the first time in eight years as buyers found themselves stretched by affordability, according to Nationwide Building Society. Even though low interest rates have helped reduce monthly mortgage costs, in reality, more people have found themselves priced out of the housing market especially in London and the South of England or have had to borrow (Meakin, 2016). On the other hand, home owners with variable mortgages will be the beneficiaries of low interest rates as it normally leads to lower monthly repayments.
CONCLUSION
For the United Kingdom’s economy to continue to thrive it needs to balance the desire to support the economy while ensuring that inflation – which is likely to rise following the fall in sterling – remains under control. It is therefore vital for members of the Bank of England’s MPC to make timely decisions based on well researched facts as the impact their decisions have impacts individuals, businesses, housing and the economy.
REFERENCES
Andreas Whittam Smith (2016). Low interest rates revived the economy, but now we’re all suffering for it. The Independent, 13 April. Available from http://www.independent.co.uk/voices/low-interest-rates-revived-the-economy-but-now-were-all-suffering-for-it-a6982256.html [Accessed 7 January 2017].
Bank of England (2016). How does monetary policy work? Monetary Policy. Available from http://www.bankofengland.co.uk/monetarypolicy/Pages/how.aspx [Accessed 7 January 2017].
BBC Business News (2011). Bank of England MPC: Who sets UK interest rates? BBC News. Available from http://www.bbc.co.uk/news/business-12997437 [Accessed 7 January 2017].
Economics Online (2012). The UK housing market. 1. Available from http://www.economicsonline.co.uk/Competitive_markets/The_housing_market.html [Accessed 7 January 2017].
Khan, M. (2016). UK unemployment rate unchanged at 4.9% after Brexit. Financial Times, 14 September. Available from https://www.ft.com/content/953671ba-b784-37f6-8f29-45402e846d50 [Accessed 7 January 2017].
Laub, Z. and McBride, J. (2015). The Group of Seven (G7), formerly the Group of Eight (G8). Council on Foreign Relations. Available from http://www.cfr.org/international-organizations-and-alliances/group-seven-g7/p32957 [Accessed 6 January 2017].
Meakin, L. (2016). London House-Price Growth Lags Behind U.K. First Time Since 2008. Bloomberg, 29 December. Available from https://www.bloomberg.com/news/articles/2016-12-29/london-house-price-growth-lags-behind-u-k-first-time-since-2008 [Accessed 29 December 2016].
Pettinger, T. (2013). Effect of Lower Interest rates. 10 December. Available from http://www.economicshelp.org/blog/3417/interest-rates/effect-of-lower-interest-rates/ [Accessed 6 January 2017].
The Economist (2016). It costs a lot more to fund a modern retirement. Employers, workers and governments are not prepared. Fade to grey, , 8. Available from http://www.economist.com/news/briefing/21707560-it-costs-lot-m…nd-modern-retirement-employers-workers-and-governments-are-not [Accessed 17 December 2016].
Trading Economics (2016). United Kingdom Interest Rate | 1971-2017 | Data | Chart | Calendar. Available from http://www.tradingeconomics.com/united-kingdom/interest-rate [Accessed 6 January 2017].
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