The Bank of England has announced its first interest rate cut since March 2020. This is welcome news for many British homeowners as it will likely lead to lower mortgage repayments.
The last time interest rates were dropped was in the early days of the coronavirus pandemic, when they were slashed to a record low of 0.1% in an attempt to boost the economy. And since August 2023 the Bank of England has held rates at a 16-year high of 5.25% in an attempt to battle inflation across the UK.
We look at what’s been happening and, importantly, what it means for your savings and investments.
First things first – what are interest rates?
Interest rates tell you how high the cost of borrowing is, or how high the rewards are for saving.
In this article we’re specifically talking about the interest rate set by the Bank of England – commonly known as the base rate. In the US, the base rate is set by the Federal Reserve and in the Eurozone by the European Central Bank.
How does the base rate affect you?
The rate that a central bank, such as the Bank of England in the UK, charges to commercial banks has an impact on what they charge you for loans and mortgages, and also what interest rate you get for saving with them. So, the cost of borrowing and the returns on your savings depend to a large extent on the base rate set by the Bank of England.
If the base rate rises, banks have to pay a higher rate to obtain money, meaning the cost of mortgages and other loans usually rises too – which has been the case since August 2023. On the other hand, you should be earning more interest on your savings if the rate is high. It’s worth shopping around though to make sure you’re definitely getting the best interest rates on your savings accounts as banks don’t always pass on the full interest rate rise to savers.
The base rate plays a crucial role in economic policy too
The Bank of England uses the base rate as a tool to control inflation – which is why it has been held at a 16-year high until now. The theory is the higher the base rate, the more incentive individuals and businesses have to save rather than borrow money: they’ll be getting higher returns from their savings but have to pay more for any loans. So, if inflation gets too high, the Bank of England is likely to increase the base rate to encourage us all to spend less and to save more. In turn, it hopes this will help to bring price rises – inflation – back under control.
And that’s just what’s happened
The Bank of England has managed to bring inflation back under control and meet its inflation target of 2%. As a result, the Bank of England are now in a position where they can cut interest rates.
The Bank's Monetary Policy Committee meets eight times a year – roughly once every six weeks. However, the clear message from Andrew Bailey, Governor of the Bank of England, was not to expect a consecutive series of cuts from here.
While there may be scope for a further reduction this year below 5%, perhaps in November, the governor of the Bank of England wants to avoid cutting too quickly or by too much as inflation is expected to creep back up from the target of 2% over the next few months.
What does this mean for savings?
The interest rate cut will be welcome news for homeowners without a fixed rate mortgage, and as the rate cut is small there shouldn’t be too much of a loss for savers looking to see a boost to their returns. Savings rates will continue to significantly outpace inflation, which as noted above is currently just 2%, but by a slightly narrower margin. But as inflation may rise again, it’s important to remember that the interest you earn on cash savings could fall below the rate of inflation, and so the value of your money could decrease in real terms. It’s something to keep an eye on.
What does this mean for investments?
When it comes to your investments – falling interest rates are usually a positive for stock markets as they suggest a boost in economic activity will follow. Before the Bank of England’s announcement, the chances of a rate rise were very much in the balance, with markets pricing in around a 50/50 chance those on Threadneedle Street – home to the Bank of England – would act on Thursday.
After the announcement, the Bank of England was quick to temper expectations that this would be the start of a prolonged and relatively quick series of rate cuts, striking a more cautious tone, with the Governor, Andrew Bailey, commenting that: ‘we need to make sure make sure inflation stays low, and be careful not to cut interest rates too quickly or by too much’.
The Bank of England expects headline inflation to rise to 2.75% in the final quarter of the year, from its current 2% level, as the effect of last year's steep falls in energy prices fades, before returning and staying on track towards its 2% target in early 2026, with subsequent rate cuts being paced slowly and thoughtfully.
Because of this forward guidance, abrdn Investment Analyst, Tom Watts believes the pace of loosening will be gradual and therefore have a minimal impact on markets in the coming months. Over the longer term however, history shows us that mid and small caps tend to outperform during a rate cutting cycle as well as more rate sensitive sectors such as Property and Consumer Discretionary exposed companies.
Many of these companies and sectors endured a difficult time during 2022-23 as the Bank of England continued to hike rates and will be hoping investors begin to return to what have been unloved parts of the market for a while now.
There’s support if you need it
If you want to keep up to date with what’s happening in global markets, you can read regular market commentaries from our investment experts, Thomas Watts and Craig Hoyda.
The information in this article should not be regarded as financial advice. Information is based on our understanding in August 2024. Tax rules can change in the future. Your own circumstances and where you live in the UK could have an impact on tax treatment.