Banker Blog #2 Bank of England and Base Rate

As you can see from the picture I snapped, I was recently in London on business and couldn’t resist going to see the Bank of England. Since 2008, it has become an organisation that previously shunned the limelight to being a hot topic, the governor Mark Carney constantly being interviewed and defending bank decisions.

It is common enough to see headlines in the news such as “Bank of England to cut base rate”, “Bank of England threatens to cut base rate” and “2017 could see unexpected rise in base rate”. Often they cut out the base part and discuss rates which is a fairly inaccurate term but they mean the base rate.

These same stories never bother to explain what the base rate means, how it is decided, why someone would raise or lower it. It is left so vague I sometimes wonder if the journalists writing the articles even know. Like a lot of these banking terms, it is very simple.

What is the Bank of England?

The central bank here in the United Kingdom, comparable to the Federal Reserve in the United States, Banque de France in France and Deutsche Bundesbank in Germany.

What does it do?

Like all central banks, it is concerned with the stability of the financial system, currency and managing booms and busts.

What is the base rate?

  • Banks use the base rate in their calculations.
  • Banks will often charge a loan as “base rate + 4%”
  • Banks will have the deposit on their accounts for interest as “base rate + 2%”
  • So lets say the base rate is 1, and your loan is Base rate +4%. Then 1+4%, so 5%.
  • Note- It is possible to have a fixed rate on your loan, where there is no base rate element but most are base rate linked.

Why lower the base rate?

Keeping that in mind, if the central bank wants to encourage growth, it slashes the base rate. That way if you want to start a company, buy a house, buy a car, the loans you take it to do it are very cheap. Slashing the base rate makes loans cheaper. How?

Using our last example-

  • Your loan is Base rate + 4%
  • Base rate before the Brexit referendum was 0.5.
  • Your loan- 0.5+4%, you are paying 4.5% interest on your loan.
  • Base rate post Brexit is cut to 0.25.
  • You loan is Base rate + 4%,
  • Your loan- 0.25 + 4%, you are paying 4.25%
  • So you were paying 4.5%, now you are paying 4.25%, so you will be very happy with the base rate cut. If you have a lot of debt or want to take out a loan but aren’t too sure, big cuts to the base rate will help you.

However, it also means less money is generated by interest. So if you are a millionaire living off the interest in your accounts, you might be cursing a base rate cut.

Cut the base rate to encourage growth and innovation if the economy is stagnant. It makes loans and financing cheaper, so people are more likely to do it.

Why increase the base rate?

If the economy gets too hot, it may need to cool down. People are spending too much, taking out too many loans, the whole thing is just overheating and barrelling forward (think before the 2008 crash). You can allow this to continue but history has shown it results in an extreme crash and even depression. Some countries are okay with this but most aren’t.

Pushing up the base rate makes it better to sit with savings (you get more interest), it makes loans, credit cards etc more expensive, so you will see less start ups and risky business moves.

Think of it this way, making it more expensive to expand and grow lets everyone catch their breath, cool their heads and consider what they are doing. The Bank “takes away the punch bowl when the party gets too crazy” is the analogy I frequently hear.

Let’s use the previous example again.

  • Your loan is Base rate + 4%
  • Base rate is 0.25.
  • Your loan- 0.25+4%, you are paying 4.25% interest on your loan.
  • Base rate is increased to 1%.
  • You loan is Base rate + 4%,
  • Your loan- 1 + 4%, you are paying 5%
  • So you were paying 4.25%, now you are paying 5%. It will take more of your resources to pay for that loan, you will be less inclined to take out more loans or take riskier ventures. You bide your time for a year or two until the base rate is lowered again.

 

What to take from this blog?

The Bank of England website shows all the times the base rate has changed and it isn’t as frequent as you might think. When the base rate change does happen, it will be an attempt to guide the economy. So if a newspaper screams the end is nigh because the base rate is cut, if you have a lot of loans or want to take out a loan, you would actually be pretty happy about that. If you make your money from the interest on your deposits, you would be very annoyed by this.

If the base rate is increased, yes it makes financing more expensive and puts people off loans, but it can also be a good time to stay still and catch your breath a bit, see some decent interest on your savings and bide your time.

I can’t stress this enough, a base rate cut or rise will be good or bad for different people- neither is universally a bad thing.

Further reading

This is a pretty fundamental banking concept, try any university level coursework book and it will go into further detail.

 

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