The Interest Rate Debate: Is It Time To Lower Interest Rates?

Introduction

The recent decrease in UK inflation over the last few months has sparked a lively debate as to when the Bank of England Base Rate should be lowered. Set by the Monetary Policy Committee at the Bank of England, this Base Rate, hereafter referred to as simply the interest rate, sits at 5.25% as of January 2024 and is at its highest level since February 2008.  The rise of the interest rate began in March 2022 at 0.5% and continued to increase steadily on an almost month-by-month basis, eventually reaching the current rate of 5.25% in August 2023. 

The Bank of England's decision to increase the interest rate has been a direct response to high levels of inflation, which will be examined below. Despite the importance of a higher interest rate to combat high inflation, a high-interest rate can become subject to criticism when the inflation rate decreases. This is because a higher cost of borrowing can create a barrier to accessing finance. These barriers can have negative impacts on businesses, such as reducing expansion, restricting commercial investments and dampening overall investor appetite.  Against this background, trends in recent inflation data have led to market expectations for the Bank of England to cut the interest rate in the upcoming months.

Inflation Trends: Why does the market expect an interest rate cut?

The term inflation can be defined as the rate of rise in the price of goods and services. If levels of inflation are high, the Bank of England will seek to raise the interest rate, setting a benchmark for interest rates at other commercial banks. This increase counters high levels of inflation by affecting the overall level of spending in the UK. This is achieved because the cost of obtaining finance, ie loan interest repayments, increases along with the interest rate, making it more expensive to borrow money from banks and thus encouraging individuals to save rather than spend. This trend then pushes prices down and thus counters high inflation.

The Consumer Price Index, which is the most common method to measure UK Inflation, began to increase in March 2022 and hovered at levels of around 10% from July 2022 up until March 2023. After March 2023, the rate of inflation began to steadily decrease from 10%, falling to 6.80% in July 2023 and eventually to 3.90% in November 2023. Despite a small increase of 0.10% in December 2023 to 4.00%, it is clear that the inflation rate has rapidly declined from its double-digit peak. This has created the impression to the market that the UK has gained control over spiralling inflation.

With this feeling of control, the market has begun to expect interest rate cuts to follow in the upcoming months. Investor expectations are firmly subscribed to the position that the interest rate will be lowered by the end of 2024. Paul Dales, chief UK economist at Capital Economics, forecasts that "interest rates will be reduced from 5.25% now to 3.00% in 2025".  He further predicts that "the first interest rate cut from the Bank of England will happen in June this year". Similarly, Ruth Gregory, deputy chief UK economist at the same institution believes that economic factors will "drag CPI inflation below the 2 per cent target by April, leaving the Bank of England in a position to cut interest rates by June”.

The expectation that the interest rate should be cut is rooted in a shared optimism held by investors that the worst of UK inflation has been overcome. Arguably, a high-interest rate is harder to justify in an economic environment where inflation rates have been tamed. With a higher cost of borrowing, companies can be dissuaded from pursuing economic opportunities, such as expanding business operations, pursuing new business ventures or borrowing capital to reinvest in existing projects. This can hamper a company's ability to remain competitive in its market and have the wider impact of creating a slowdown in overall economic activity. The argument that the current interest rate should be cut in the following months recognises these negative impacts and argues that it is not suited for the current economic climate in the UK, in which the issue of inflation has been successfully tackled.

The UK's Road Ahead: Slow and Steady

 Although the rate of inflation is heading in the right direction, it is extremely unlikely that the interest rate will be lowered back to its March 2022 rate of 0.5% by the end of the year. This reflects the Bank of England's cautious approach. In December 2023 Andrew Bailey, the governor of the Bank of England, warned that "there is still some way to go" and that "it was too early to speculate about interest rate cuts". As we entered the month of February 2024, he further reiterated that "we need to see more evidence that inflation is set to fall to the 2 per cent target and stay there, before we can lower interest rates." Following this, the Bank of England has decided to keep the interest rate at 5.25% for February 2024.

This cautious approach reflects the fact that the rate of inflation can be influenced by a wide variety of economic and geopolitical factors, as seen with energy prices and the crisis in Ukraine. Furthermore, cutting interest rates too soon could undo progress and trigger inflation to rise again. The cautious approach further recognises that a reduction in the interest rate by the Bank of England would send a strong message to the market, with investors likely interpreting this message to indicate a path of further interest rate cuts in the future. A miscalculation by the Bank of England could create an ugly situation in which recent interest rate cuts are reversed to combat new inflationary pressures, which in turn muddies the waters of investor expectations and market practices.

Despite these market concerns, the negative consequences of high-interest rates should also be considered by the Bank of England. The weight of higher borrowing costs is not just felt by companies but also by individuals, who may struggle to access finance or repay their existing financial agreements. One example of the latter can be seen with non-fixed mortgage rates, with high-interest rates often leading to higher monthly payments for individuals. This can create financial burdens and have a significant impact on an individual's overall cost of living. Therefore, the Bank of England should weigh these considerations when deciding how to approach the interest rate debate, as the wider societal impacts of high-interest rates cannot be ignored.

The sense of optimism in the market for a reduction in the interest rate is unlikely to dissuade the Bank of England from its current approach, which is rooted in caution. This has the potential to create a gap between market expectations and the Bank of England's policy going forward, which would only add momentum to the interest rate debate.  As the inflation rate gets closer to the Bank of England's target of 2.00%, it will be harder for the bank to ignore investor expectations. Therefore, the next few months will be crucial for setting the tone of the debate and the overall view as to whether the issue of inflation has been successfully tackled in the UK.

Whilst, it is likely, that interest rate cuts will occur by the end of the year, these cuts are unlikely to occur over the following months. The journey to interest rate cuts will only begin when the Bank of England's inflation target of 2.00% is met. Furthermore, interest rate cuts will be gradual rather than drastic and will likely see the interest rate reduced in small increments, reflecting the Bank of England's slow and steady approach to the interest rate debate and overall cautious campaign in tackling persistent inflation. Although there are positive signs that the inflation rate is heading towards this target, market expectations of interest rate cuts before this target is met are overly optimistic.

Conclusion

The interest rate, which currently sits at a 12-year high of 5.25%, has increasingly come under scrutiny as the market begins to expect interest rate cuts following falling inflation. When looking at the interest rate debate, it is clear that there are arguments both for and against the Bank of England's cautious approach. Those in favour of this approach argue that a high-interest rate continues to be a necessary tool to tackle persistent inflation and that reducing the interest rate too quickly could undo progress and trigger inflation to rise again. Proponents for reducing the interest rate in the following months are driven by the view that the challenges of high inflation have been overcome and emphasise the negative consequences of a high-interest rate, such as restricting access to finance and creating a hostile economic environment for companies and individuals. As the inflation rate continues to move closer to the Bank of England's 2.00% target, the interest rate debate will continue to gain more momentum.

By

Edward Berry