Interest rate cut: what will it mean for the UK economy?

Consumers, homeowners and businesses are braced for the first interest rate cut in more than seven years next week.

The Bank of England governor, Mark Carney, is expected to announce on Thursday that the cost of borrowing has been reduced from its current record low of 0.5% to 0.25%.

Carney and his fellow members of the monetary policy committee (MPC) sat on their hands in the immediate aftermath of the Brexit vote, but there is clear anticipation that they will act decisively this time. All but three of 49 economists polled by Reuters forecast a cut to 0.25% or even lower.

The MPC’s decision will be influenced by fresh data that has raised concerns about the state of the economy after the referendum. The first health check of the economy since the 23 June vote, published a week ago, showed the sharpest downturn in activity since the peak of the financial crisis seven years ago.

What will a rate cut mean for the consumers, the banking sector and the broader economy?

Consumers

The decision by the Post Office on Friday to withdraw its three-year bond paying 1.3% is a clear illustration of the impact already being felt by savers. According to the data provider Moneyfacts, 156 cuts were made to individual savings accounts during July.

“It is currently a dismal time to be a saver. Not only have they had to put up with years of tumbling returns, but the possibility of a base rate cut will only lengthen savers pain further,” said Charlotte Nelson of Moneyfacts.

There are a few two-year bonds paying 1.8% interest, but from little-known providers. Big banks are paying much less, including 1% on a two-year bond at Lloyds. Even this may come down if the base rate falls next week. Some observers says savings rates could fall to virtually zero.

“Savers have seen interest rates tumble to historic low levels and whilst providers do not have to pass any cut in base rate on to customers the likelihood is that they will use it as an excuse to cut rates,” Nelson said.

A further rate cut will result in catastrophically low levels of income from new annuities. An annuity is a regular payment from the pot of money a pension plan holder has accumulated during their working life, so pensioners will be thankful such products are no longer compulsory.

For borrowers with tracker deals that are pegged to the UK interest rate, monthly costs will fall from September. The Nationwide building society has just under 600,000 people on its “base mortgage rate”, which is charged at 2% above the Bank base rate.

A borrower with a £150,000 Nationwide mortgage will see repayments cut from £673 a month to £654 if Carney cuts interest rates to 0.25%. Interest-only mortgage customers will see the cost of servicing a £150,000 loan drop from £313 a month to £281. Borrowers on fixed rate deals will see no change, but deals should get cheaper in the next few weeks, with two year fixes below 1% and five year deals under 2%.

The “standard variable rate”, however, the rate people move on to after the end of a fixed rate deal, is likely to remain static at most banks and building societies. Santander’s is high at 4.74%, while Halifax’s is 3.99%. Even so, an interest rate cut may stabilise a nervous housing market hit by Brexit, and give buyers confidence to go ahead.

It could also weaken the pound further against other big currencies, pushing up costs for holidaymakers and raising the price of imports to the UK. If import costs rise then inflation could rise too, bringing increases in day-to-day expenditures such as food.

Banking sector

Banks and building societies are dusting down the procedures for informing millions of customers of changes to their lending rates. Letters will have to be sent and adverts may be placed in national newspapers.

This a logistical exercise for the lending and savings institutions, but it also has implications for the way they operate. They will have to decide whether to pass on the full cut to savers and borrowers. They regard it as a competitive decision. Lloyds Banking Group would not admit on Thursday how it intended to respond, but it did reveal that a quarter point cut would shave £100m off its profits.

Jes Staley, the chief executive of Barclays, said on Friday that the bank would not be knocked too badly by a cut on the scale currently envisaged, but he questioned the merits of cutting rates much deeper than that. Referring to the decision overnight by the Japanese central bank not to cut its rates, he said: “I personally think after what happened in Japan, I think central bankers are increasingly questioning negative, let alone, zero interest rates, in terms of what they do to generate economic activity and what they do to their own financial system.”

The lower interest rates get, the harder it is for banks to make a profit on the difference between what they can offer savers and charge borrowers. António Horta-Osório, Lloyds’s chief executive, is also expecting rates to fall by a quarter of a percentage point, but does not think they would go below zero because of the negative signal this would send about the economy. Assuming the rate cut comes, it could remain in place for some time. Virgin Money is operating on the basis that rates will remain low for at least three years.

There is also speculation that the Bank of England could turn on measures used during the banking crisis to counter a credit crunch. One way might be to revive the funding for lending scheme, which offered banks cheap money provided they pass it on to customers and households. Staley, however, said Barclays did not need such incentives to keep the lending taps on.

The wider economy

With interest rates already at a record low, the potential for any further cuts to fire up the post-referendum economy are limited.

The Bank could reach for other measures beyond just tweaking official borrowing costs and expand its already sizeable money-printing programme known as quantitative easing.Economists are cautious about predicting exactly what policymakers will do beyond cutting rates, and the MPC members are also engaged in a public debate.When the Bank kept interest rates on hold after the Brexit vote, it dropped heavy hints in an accompanying statement that a cut was around the corner.

The Bank’s chief economist, Andy Haldane, has gone further, calling for a major package of measures to support the UK’s post-referendum economy and stressing the need for a prompt and robust response to the uncertainty. Other committee members have been more restrained in their calls for action, which has drawn a sympathetic response from some economists. .

“I think they want to retain bullets,” said Tim Graf, the head of macro-strategy for Europe at State Street Global Markets. “And I am not certain given the experience on low rates elsewhere and negative rates elsewhere that they want to go that aggressive in total.”

Graf expects the Bank to cut by 25 basis points and “probably look at something like the funding for lending scheme”.

Economists at Bank of America Merrill Lynch also expect a cut to 0.25% and some fresh quantitative easing and credit easing measures. They too highlight the limited power of the central bank and the need for fiscal policy. “The fundamental issue with all the monetary policy tools we can think of is that they are close to pushing on a string,” write economist Robert Wood and strategist Sebastien Cross at the bank.

With that in mind, they say the Bank should “do ‘too much’, do it early hoping that reduces the need for further stimulus later and do everything in the hope that at least something works”.

Carney rebuffs the charge that monetary policy has lost its firepower, but he too has made clear that central banks alone cannot be relied on to shore up the economy and that government action is needed too.

While it waits for action from the new government, the Bank faces a difficult balancing act. Cut rates too far and there is a risk of causing damage to the financial sector and savers that would be counterproductive. A drastic move might also spark panic in financial markets, while not cutting at all would deal a serious blow to the Bank’s credibility after it signalled action.

What the Bank will hope to do is to lift sentiment, allay jitters about the housing market and so keep that all important driver of the UK economy -consumer spending - going.