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In the UK, interest rates have now been so low for so long that even those who are, technically, old enough to remember the double-digit inflation of the 1980s, may have forgotten what it meant in practice.  It meant that cash deposits could bring could returns for savers – but borrowing could be eye-wateringly expensive.  With Brexit on the horizon and a “no-deal” looking close to certain, now may be a good time to go over interest rates, the theory and practice.

When currencies weaken, interest rates tend to go up

The Monetary Policy Committee of the Bank of England is tasked with keeping inflation at exactly 2%, but since this is the real world, it is allowed a 1% “margin of error” either way.  If inflation falls below 1% or rises above 3%, however, the Bank of England has to write an open letter to the chancellor explaining what it intends to do about it.  If inflation falls below 1%, the BoE has two options.  It can lower interest rates (assuming there is room for it to do so) or it can implement a programme of quantitative easing.  When inflation goes up, however, the BoE’s only option is to increase interest rates.

The Brexit question

If Sterling weakens due to Brexit (or for any other reason), it will increase the cost of importing goods from overseas.  If this cost is offset by gains elsewhere, such as inbound tourism, then the net effect may be zero (or close to it), but if it is not, then either the UK will have to cease (or severely limit) its imports and/or inflation will increase and in the latter case the BoE will be forced to raise interest rates to meet its 2% target.

The only other option would be for the government to change the inflation target in some way, either by permitting inflation to go higher or by changing the means by which it is measured (such as the change from the Retail Price Index to the Consumer Price Index).  This is certainly possible, but it would be politically challenging.  Allowing inflation to rise would potentially impact everyone, including borrowers, whereas allowing interest rates to rise would benefit savers but hurt borrowers. Raising interest rates would also, at least potentially, make Sterling more attractive on the international markets, thus potentially bringing the value of the currency back up and lowering inflation naturally.  Having said that, this tactic did not work for John Major back in 1992, when the UK exited the ERM.

What this means in practice

In very blunt terms, Brexit could mean that savers finally get to see better returns on their cash deposits and borrowers start to see an increase in the cost of financing their debt.  Having said that, it is still very possible that savers will not see enough of a benefit to make it worth their while to readjust their asset allocation in favour of cash.  Borrowers, by contrast, will have no option but to swallow up the higher interest rates as they will be reflected across all lenders albeit to varying degrees.  This means that it is now critically important for borrowers to do everything in their means to pay down debt as quickly as possible and the higher the level of interest payable on the debt, the more important it becomes to pay it down.  If borrowers are unable to pay down their debt immediately, for example, if they have mortgages with long terms, then it may be worthwhile to switch to a fixed-rate product so at least they will have the security of knowing what their payments will be over the life of the product.  As always, however, individuals will need to do their own sums to see if this approach makes sense in their own situation.

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Taryn

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