The BoE and the future of interest rates

This article first appeared in Professional Adviser.

Simon Goldthorpe takes a look back at the Bank of England’s history and how its past may shape the future of interest rates.

With many people panicking at the thought of their savings being quietly eroded by negative interest rates, history could provide some valuable perspective. You might even be surprised by the important role that banks have played in shaping our national financial habits and influencing government policies.

The Georgian era encouraged a culture of saving

It was really in the 18th century that the central bank began to impact the lives of ordinary people – chiefly by encouraging widespread saving.

Before this period, people tended to keep their money in physical cash or movable goods. But with stable interest rates throughout the century, many switched to saving in banks or investing in gilts (what Jane Austen would have called “the five percents”).

The steady interest rates wouldn’t last forever, but the effect that they had on the growing British middle classes would. The impetus for saving over simply hoarding cash saw many achieve the financial resilience that would later enable them to invest in industry when the opportunity arose.

The 19th century

By the 19th century, the Bank of England was beginning to assert much greater influence over monetary policy, and the rate of inflation could now be controlled in a meaningful way to influence the economy.

In the 1840s, low interest rates coincided with growth in major UK industries, and many people wondered if they might get better returns through private investment than through gilts.

The established culture that valued saving and prudence meant that many members of the middle class had enough wealth to invest without risking their financial wellbeing. In turn, the boom of investing helped to fund yet further growth in manufacturing and transport links, including the railway network.

The UK’s first housing boom

In the 20th century, the Bank of England’s dominance in the UK financial sector allowed the Government to use its control of interest rates as a political tool.

Low rates for borrowing helped the Government begin the recovery from the Great Depression by investing in British businesses and funding construction projects, which boosted employment and created a house-building boom. They also proved useful in the years before and during the Second World War, as the fight against Hitler required production of materials on an unheard-of scale.

However, the best-known example of the Government using interest rates to influence the economy is perhaps Margaret Thatcher’s fight against the rampant inflation of the 1970s.

The monetarist policies pursued by the Conservative government resulted in official interest rates being raised to 17% in order to reduce inflation, which peaked at 25% in 1975.

The paradigm shifted once again under Tony Blair in the 1990s, when the Government handed control of interest rates back to an independent Bank of England. They hoped to lay the groundwork for economic prosperity, with the Bank now free to decide monetary policy irrespective of politics.

Whilst control of interest rates is a useful tool for any administration, political meddling isn’t always best for the economy.

Cheap credit could boost investment

So where are we today? Unfortunately, like so many nations, we are drowning in debt. A situation made substantially worse by the coronavirus pandemic.

Rumours are rife that the Bank is considering negative interest rates as a way of encouraging economic growth, and the logic of doing so is simple enough: if it costs you money to keep large amounts of cash in the bank, you’re probably going to withdraw it and spend it.

But of course, the potential negative impact of this move on many ordinary households is one of the reasons why it’s often seen as a weapon of last resort.

For a start, while keeping money in cash isn’t the best way to grow it, cash savings do provide a useful financial cushion when times get tough. Incentivising people to remove some of the stuffing from that cushion at a time of economic uncertainty may not be wise.

Furthermore, encouraging people to withdraw their cash can reduce banks’ liquidity and affect their ability to lend, which could itself detract from economic growth.

Nevertheless, it is worth noting that negative interest rates – while sounding extreme – have already been used in several first-world economies, such as Switzerland, Germany and Denmark, without disastrous consequences.

Although negative rates can punish savers, they can also facilitate cheap loans. A small number of negative-interest loans are already available in Germany for those with good credit, albeit with a cap of €1,000.

Loans like these could enable the investment that would allow UK businesses to expand and adapt to the brave new world of the post-pandemic economy.

While we may be moving into uncharted territory, our national past and our economic present prove that there is no need to panic. Throughout history, changing interest rates have posed both challenges and opportunities for those who are able to change with the times – and now is no exception.