UK interest rates cut to lowest level ever

As declared by The International Monetary Fund (IMF), United Kingdom's economy is expected to shrink by 13% this year as a result of the enacted lockdowns in response to Covid-19, rendering a grave possibility of its deepest recession in three centuries, supplemented with the unemployment rate more than doubling to 10% and economic output plunging by 35%.This commentary will analyse the Bank of England’s decision to lower their interest rate to the “lowest rate ever” - 0.1% to combat this economic upheaval caused by the Covid-19 pandemic.

Expansionary monetary policy refers to the actions undertaken by a nation's central bank to stimulate the economy. Lowering the rate of interest is a fundamental expansionary monetary policy being employed by the Central Bank of England, in a valiant and aggressive effort to alleviate the economy from its current state of recession.

This aggressive interest rate cut by the Central Bank will first feed through a transmission mechanism - a number of channels affecting the aggregate demand - before reaching the grassroot economy. It will reduce the cost of borrowing for consumers in the form of for example credit card interest rates, lower the saving interest rates, reduce the mortgage and loan rates, lower interest rates for business loans, each of which will increase the marginal propensity of consumers and businesses, increase their disposable income - inherently increasing consumption spending and investment. Furthermore, lower interest rates across the economy can serve to weaken the exchange rates. As individuals and firms have reduced incentive to ‘save’, they may develop the tendency to move their savings out of the United Kingdom, to countries with higher interest rates, in the form of ‘hot money outflows’. This increase in money supply, will render a depreciation of the ‘pound’, further augmenting net exports. Therefore, as unveiled by diagram 1.1, this increase in consumption, investment, and net exports - the primary determinants of aggregate demand, will result in a rightward shift of the AD curve from AD1 to AD2, increasing real GDP and eliminating the recessionary gap.

However, rigorous reduction of the rate of interest to an exceptionally low rate, as done by the Bank of England - “The fresh rate cut takes interest rates to the lowest they can feasibly go” - can have dire consequences on the economy. During a pandemic ameliorating covid-19, there is often a conflict of macroeconomic objectives, with government agencies prioritising economic growth and unemployment. As indicated in Diagram 1.1, the excessive increase in Real GDP - reflecting the economic growth and rate of unemployment - may result in demand-pull inflation, exceeding the inflation target for the economy. If this inflation rises above the nominal interest rates, the real return on savings could become negative, rendering a fall in the standard of living in the economy. Secondly, the United Kingdom has a trade deficit of £72 billion and an account deficit of 4% of GDP as of 2019. Lowering the interest rate to 0.1%, and potentially lower, will have the effect of a drastic increase in incomes, increasing expenditure on imports, and further widening these already substantial account and trade deficits. Thirdly, given the uncertainty regarding covid-19, consumers and businesses have the tendency to convert their illiquid assets into liquid assets like cash, in an attempt to hoard it due to lack of security. Following the Keynesian idea that interest rates have a lower bound, this may result in a liquidity trap, wherein due to having enough cash, there will be a reduced tendency of borrowing, yielding no substantial increase in spending or investment, and lowering interest rates ineffective. Moreover, taking into account the exceedingly low consumer and business confidence due to covid-19, incentives in addition to mere low interest rates will be required to boost borrowing, consumption and investment.

Therefore, expansionary monetary policy in isolation may be detrimental and ineffective, and must be supplemented with an equally strong expansionary fiscal policy in the form of reduction in income and business taxes, yielding a higher marginal propensity to consume and increased government spending in sectors such as healthcare, disaster management and corporate aid to increase the productive potential of the economy thus boosting consumer and business confidence.

However, the transmission mechanism of both monetary and fiscal policy takes a long time to feed through the different channels, and the effect on aggregate demand tends to become a long-run effect. Although an effective combination of monetary and fiscal policy should be employed to yield lasting relief, in the case of a pandemic like covid-19 which has immediate repercussions on the economy, it is imperative to take into consideration the short run. The aforementioned impact of short term interest rate reductions on investment, combined with fiscal policies such as reduced income tax, which stimulate improved quality and quantity of labour and increased productive potential of the economy, further lend to stimulate a rightward shift of the LRAS curve as shown in diagram 1.2. This sustained increase of aggregate supply in the economy creates the grounds for increased quantitative easing to yield instantaneous relief.

Quantitative easing, the introduction of new money into the national supply by a central bank who purchases existing government bonds, aims to support the level of aggregate demand and maintain the level of inflation. As stated in the article, this process has already been initiated by the Bank of England through their “holdings of government and corporate bonds by £200bnin” . The bank should further these purchases of bonds, using open market operations and increasing the injections of cash flow into the economy. The purchase of these bonds will increase the excess reserves and liquidity of commercial banks from whom these are bought, stimulating an increase in borrowing, loan-financed capital investment, and the yield of other assets such as shares, encouraging the wealth effect. The increased ease of borrowing and consumer confidence facilitates increased consumption and investment, directly increasing aggregate demand and alleviating the recession.