What Is The Impact Of A Bank Of England Interest Rate Hike?

On 2 November 2017, the Bank of England (BOE) raised interest rates for the first time since 2007. Citing concerns over higher than expected inflation and below target unemployment, the BOE voted in favour of raising the Bank Rate from 0.25% to 0.50%.1)Retrieved 11 November 2016 https://www.theguardian.com/commentisfree/2017/nov/02/bank-england-increased-interest-rates-only-option-government-austerity-blame Headed by acting BOE Governor Mark Carney, the Monetary Policy Committee voted 7-2 to implement the rate hike.2)Retrieved 11 November 2017 https://www.bloomberg.com/news/articles/2017-11-02/boe-raises-interest-rate-for-first-time-in-more-than-10-years

In the wake of 2016’s vote for Brexit, many viewed the shift in monetary policy as being inherently risky. The BOE acknowledged the skepticism, stating that any future upward moves were to be conducted at a modest pace to avoid placing undue strain upon the U.K.’s economy.3)Retrieved 11 November 2017 https://www.bloomberg.com/news/articles/2017-11-14/boe-on-a-one-a-year-path-when-it-comes-to-interest-rate-hikes The verbiage came as reassurance to the financial community, and an acknowledgement of the post-Brexit fragility that plagued the nation’s industry.

What Is The Impact Of An Interest Rate Hike?

When a central banking authority makes the decision to raise a benchmark interest rate, the primary goal is to reduce the domestic monetary supply. For this reason, the action is called “tightening” because of the fact that money will become more scarce. A policy of tightening is typically warranted by numerous factors, but the main reason is the growth of inflation. In the event that inflation becomes unmanageable, currency value, consumption, savings and spending become destabilised.

The action of raising interest rates by a central bank has several traditional results, both in the world of finance and on high street:

Finance High Street
Economic growth (GDP) slows Increase in personal savings rates
Inflation decreases Decrease in consumption/spending
Credit markets shrink Credit card rates increase
Domestic currency appreciates Home purchases reside

Rising rates for mortgages and auto loans are also commonly passed on to the consumer, but the degree depends largely upon other market-related factors.

An extended period of incrementally rising interest rates has the greatest impact upon the valuation of the domestic currency itself. As a central bank hikes rates, traders and investors debate the currency’s future value, which sends a shockwave throughout the domestic economy.

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BOE Rate Hike: Impact Upon The GBP

The typical reaction of a domestic currency faced with an interest rate hike is an increase in market value. For the British pound (GBP), the reaction to the November 2017 BOE move was unconventional.

Going into the release, the consensus among analysts and industry professionals was that a raise in rates was a foregone conclusion. In a poll conducted by news outlet Reuters one week ahead of the announcement, 46 of 64 economists expected a BOE rate hike.4)Retrieved 12 November 2017 https://www.reuters.com/article/uk-britain-sterling/sterling-skids-on-uncertainty-over-boe-rate-outlook-idUSKBN1CT14Z Dovish comments from BOE policy makers in prelude to the move gave analysts and market participants reason to believe that it was to be a somewhat-isolated incident.

The GBP took the news of the 0.25% raise poorly. Immediately following the BOE announcements, the GBP posted a 1.7% loss against the euro (EUR) and a 1.36% drop against the U.S. dollar (USD).5)Retrieved 12 November 2017 http://www.independent.co.uk/news/business/news/uk-interest-rates-latest-updates-rise-bank-of-england-pound-sterling-falls-a8033376.html The initial market reaction was not typical of a rate hike, but the GBP quickly pared losses against the USD by closing the trading week down 0.9%.6)Retrieved 14 November 2017 https://www.poundsterlinglive.com/bank-of-england-spot/historical-spot-exchange-rates/gbp/GBP-to-USD-2017 In a similar fashion, the GBP rallied against the EUR by cutting losses to 0.8% at the weekly close of trading.7)Retrieved 14 November 2017 https://www.poundsterlinglive.com/bank-of-england-spot/historical-spot-exchange-rates/gbp/GBP-to-EUR-2017

As a general rule, markets are not fond of uncertainty. While the November 2017 BOE policy change made headlines, it was expected and did not create post-Brexit levels of volatility. Nonetheless, future rate hikes that come as a surprise may not be as well received.

With analysts expecting the BOE to take a further dovish stance towards the pound for the extended future, any unforeseen raising of rates has the potential to spike volatility dramatically. In the event that the Monetary Policy Committee believes consistent rate hikes are warranted, the GBP is likely to see a rapid appreciation against the other major global currencies.

Economic Impact On The United Kingdom

As one of the oldest centers of finance, the U.K is home to the world’s largest gold market and a dominant player in the forex marketplace. The U.K. is considered a global economic superpower and ranks among the elite in several traditional categories8)Retrieved 14 November 2017 https://www.cia.gov/library/publications/the-world-factbook/geos/uk.html:

Metric Global Rank
GDP, Purchasing Power Parity 10
Labour Force 18
Exports 11
Imports 5
Stock of Direct Foreign Investment 4

Foreign trade is a critical aspect of most developed national economies, and having a healthy trade balance is often viewed as a driver of economic growth and prosperity. The U.K. is held in high regard in terms of both imports and exports, with each being a substantial component of aggregate GDP. The U.S., Germany, France, Netherlands and China are all key trade partners.9)Retrieved 14 November 2017 https://www.cia.gov/library/publications/the-world-factbook/geos/uk.html

However, traditional financial theory states that a strong domestic currency can be detrimental to the viability of the export sector. Many export-dependent nations adopt passive monetary policy in order to promote economic growth. In the event that the BOE adopts a prolonged tightening policy towards the GBP, the export sector will be substantially affected.

As rates are raised, the GBP is extremely likely to strengthen against the USD and EUR. If this scenario unfolds, the price of U.K. goods and services abroad will increase. Rising costs are likely to negatively impact the export sector and slow the total growth of GDP.

Conversely, if the BOE becomes accustomed to rate hikes, the U.K. banking industry is in position to flourish. The GBP is viewed as one of the oldest safe haven assets; any precipitous rise in its value is likely to attract robust participation from foreign investors.

Summary

Although it was the BOE’s first action in ten years, the November 2017 interest rate hike came as no surprise to traders and investors. Currency markets initially reacted negatively and soon stabilised as the policy shift was deemed moderately dovish by the markets.

The impact of tight monetary policy on the U.K.’s industry, growth, spending and consumption can be substantial. If rates are raised too fast, GDP growth may stagnate due in part to challenges from the export sector and availability of credit.

While rate hikes are often appropriate, central banks walk a fine line in balancing what is in the best interests of both the financial sector and high street.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.

Past performance is not indicative of future results.

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