“Money makes the world go round” or so goes the saying and one of the most important “tools” that those responsible for governing the economy has, is the decision to raise or lower interest rates. A very cumbersome tool as it is difficult to be used in a targeted way and is set by The Bank of England (usually) 8 times per year. Crudely put, it can take billions out of the economy (or put billions in) at the swipe of a pen. Here’s how it works:
Imagine you are a borrower and have a mortgage and perhaps a loan or credit card. The borrowers amongst us tend to be the spenders – and spending tends to be good for economic activity. In other words, the money the “spenders” spend is spent in the shops buying things and generating employment, economic activity and taxation. Where interest rates are low, the cost of servicing debts tends to be low, giving the “spenders” more disposable income and more money to spend. (because they are not using it servicing their debts!)
With interest rates now at an equal all-time historic low of just 0.25%, this means the “spenders” amongst us will be able to keep spending!
When people start spending a little too much and there is too much money chasing too few goods, shops then tend to begin putting their prices up. As goods and services become more expensive (through shops putting prices up), this in turn then leads to inflation. (inflation is costs of things rising over time – please see our article on inflation). This usually would then lead to higher inflation!
So why alter the base rate now?
One of the main objectives of the Bank of England, (as defined in law) is to control inflation and ensure financial stability. Essentially, this means a chief responsibility is to maintain inflation at the long-term target of 2%. 2% is deemed by most economists to be an acceptable rate in a modern economy and results in essentially a stable economic model. Given the problems with coronavirus and the fact that economic activity is slowing (and will probably continue to slow if many people are off work and Chinese imports can’t be gotten into the country), a short-term boost has been deemed appropriate! Problem is, if there is a recession or further economic decline, the Bank of England has left itself no “wriggle room”! Question is, could we one day see negative interest rates? Impossible – I think not!