Historical Base Rates

The sharp decline in interest rates.

Interest rates peaked in 1990 when the UK was fighting to stay in the ERM and keep the value of the Pound fixed. The combination of high interest rates and strong pound reduced the inflation, created by the Lawson boom, but, also caused a deep recession.

After the UK left the ERM, interest rates fell sharply allowing the UK to grow.

During the 1990s and early 00s, base interest rates remained remarkably stable – between 4 and 6%. This reflected the long period of low inflationary growth. However, this stability hid behind a mask of unsustainable house price rises and subprime mortgage lending.

In 2007, the house price bubble burst, and a modest recession became very deep in the autumn of 2008. This sharp downturn, led to a quick cut in interest rates as the MPC realised the extent of the economic downturn.

On the one hand the slowdown in the Housing market could lead to a wider economic slow and possible recession. On the over hand inflationary pressures are actually rising, due to a variety of cost push factors. If the bank responded by cutting interest rates, they would risk increasing inflation above the governments target of 1 -3%. This could turn the temporary cost push factors into persistant and continuous inflation; it would raise inflationary expectations and lead to higher interest rates in the long term.

However, with house prices falling and interbank lending increasing, there is also pressure for the Bank to cut rates. It looks likely that the housing downturn will get worse before it improves. If house prices were to fall by 20-25% then it would significantly affect consumer confidence and consumer spending. The UK economy has relied quite heavily on consumer spending in the past. A fall of this magnitude would definitely slow the economy.

It may come down to the question of whether they think their highest priority should be low inflation or low unemployment.

However, I think the problems in the housing market and global economy are sufficiently problematic to warrant a cut in rates. I would predict a fall of 0.5% in the next 6 months.

Higher interest rates increase the cost of mortgage repayments making it less attractive to buy houses.

In the UK many homeowners have a variable mortgage. This means that the cost of their mortgage is dependent on changes in the Bank of England repo rate (better known as the base rate)

If interest rates increase the following occurs.

• Mortgage interest payments increase, reducing disposable income of consumers
• Demand for houses falls, possibly causing lower house prices.
• Higher interest rates also make it more attractive to save rather than spend money.
• Higher interest rates also increase the value of the exchange rate, though this has little impact on the housing market.

Time Lag of Interest Rates.

When the Bank of England increases interest  rates it might take a long time before it has an effect on reducing demand. This is because people don’t respond immediately to changes in interest rates. Firstly a significant % of people have a fixed rate mortgage and therefore, they will be insulated from changes in the interest rates for the duration of their fixed rate term. However, when their term expires they will have to negotiate a new deal. If rates have increased alot they will experience a significant impact on the cost of their mortgages.

Depends on Economic Situation.

The effect of interest rates may also depend on the economic situation of the economy. If the economy is in a recession, then any increase in interest rates would have much more effect than when the economy is doing well and people have a lot of confidence.

Base Rates and Bank Rates.

When the Bank of England change interest rates, commercial banks are not forced to change their rates. Sometimes the Bank of England may cut rates, but commercial banks may decide to keep theirs unchanged and just make a bigger profit margin.