The Financial Times has reported that David Cameron is the first PM since the 1950s to enjoy a whole term with no interest rate rise. But what does that mean and why is it important?
What are interest rates and why do we have them?
Money has a time value. If you hold it you can take it to the casino and gamble it in the hope of leaving with more. You may win big or you may leave with nothing,p but the opportunity you had to increase your original stake has a value.
Now, if instead of taking it to the casino you lent your money to me, you would not be able to risk that money at the gaming tables until I repaid you. By helping me, you have deprived yourself of that opportunity.
Interest rates are the mechanism by which holders of money compensate those that provided it to them for their lost opportunity.
If you were to agree to make me a loan you would charge me an interest rate to make up for the fact that for the duration of the loan I, and not you, can gamble it. Similarly, if instead of lending me the money you deposited it with a bank, you would expect the bank to pay you interest for the period of time that it holds your money and the opportunity of making it grow.
David Cameron has enjoyed a full parliamentary term without a rise in interest rates. But which interest rate are we talking about?
There are many different interest rates for many different things. For example, banks will charge different rates of interest depending on the amount and the length of a loan and different banks will charge different rates. But Cameron is less interested in those rates.
The rate that concerns him is the interest rate that the Bank of England offers to pay to other banks that deposit their money with it: commonly known as the base rate or bank rate. It is set by the Monetary Policy Committee of the Bank of England and it is the most influential interest rate in the UK as it is used by high street banks to calculate what they will pay in interest for accepting deposits and what they will charge in interest for making loans.
Why is bank rate so important?
All politicians want us to feel better off – if we feel better off we are more likely to vote for them (or so the theory goes).
If prices rise (or inflate) too quickly the value of our money drops. If they fall (or deflate), producers make less money and think about reducing their workforce or cutting their wages so although the value of our money might rise, we may have less of it.
So high inflation or deflation make us feel poorer. So what the government wants is for prices to rise slowly: in other words, Cameron wants a low rate of price inflation.
Bank rate is important because it plays a key role in controlling prices (and therefore inflation) and – unlike many of the other factors that influence inflation such as underlying commodity prices, the amount we are paid, and the strength of the pound compared to other currencies – it is something which itself can be controlled.
So how does it work?
Prices are effected by the proportion of money that is spent and saved. If we want to spend our money, manufacturers can put up prices knowing their products are in demand. If we want to save money, prices will have to fall to tempt us to spend.
By changing the bank rate, the Bank of England can influence our decision to spend or save and therefore can influence how much money there is in the real economy.
An increase in the bank rate makes borrowing more expensive and saving more attractive: it takes money out of the economy and cools prices. A reduction in the bank rate has the opposite effect: by making saving less attractive and borrowing cheaper it encourages spending and pushes prices up.
So why is David Cameron so happy bank rate has not increased?
When David Cameron formed his coalition government in May 2010 the UK was in the midst of a financial crisis. The economy was not growing and public borrowing was at unsustainably high levels. This meant that Cameron could not increase public spending to help stimulate the economy and instead he had to rely on you and me spending our money rather than saving it. As we have seen, a low bank rate encourages us to do just that.
The more we spend the more the economy grows and the better off we feel and that’s music to the ears of any government.
But remember, since 1997 bank rate has been set by the Bank of England and not the government. Although we can now look back at a parliament of rare interest rate stability, the government has had to make its decisions without knowing for certain that this would be the case.So while it is now fact bank rate will have remained unchanged (and at a record low) throughout Cameron’s five year term, how much he has been able truly to enjoy that fact is less certain.
Cyrus Pocha is an associate in the financial services group of Freshfields Bruckhaus Deringer
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