Why Interest Rate Rises Aren’t Felt Until Months Later
In the past few years, many of us have learnt more about the UK’s financial systems than we ever thought we might. The rapid onset of high inflation post-pandemic has seen millions of households reeling from new supermarket prices and a higher cost of domestic energy; the Bank of England’s attempts to curb inflation by rising interest rates have indirectly made mortgages untenable for many.
Indeed, the Bank of England’s many concurrent hikes to interest rates have been felt keenly over time – but never immediately, even as the BoE rose rights by their highest increments in history. Why, exactly, is this the case?
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Why Interest Rate Rises Aren’t Immediately Felt
When interest rates rise, it takes time for financial markets, businesses, and individuals to adjust. Existing loans with fixed interest rates are not immediately affected, and it can take time for new loans and financial products to reflect higher rates.
There is typically a lag between when interest rates are raised and when the effects are felt in the real economy. This is because many economic decisions, such as business investments or large purchases, are made based on expectations that can take months to change.
Many loans and financial contracts are fixed for a specific period. For example, a homeowner with a fixed-rate mortgage won’t see an immediate change in interest costs.
Consumers don’t always immediately react to interest rate changes. For instance, it may take a few months for households to cut back on spending or for businesses to reduce investment due to higher borrowing costs.
Banks and financial institutions might not instantly adjust their lending rates in response to central bank rate changes. They may gradually pass on higher rates to borrowers over time.
The global economic environment can also influence how quickly changes in interest rates affect a particular country. For instance, a strong currency can help offset the impact of higher rates.
People and businesses tend to stick with their existing financial arrangements until it makes economic sense to change. This inertia contributes to the lag in feeling the effects of rate increases.
Implementation of Monetary Policy
While the UK government is, naturally, the overriding institution for design and implementation of policy, the management of the UK’s monetary system is necessarily devolved from Parliament . One major reason for this devolution of control is the potential vested interests of policy-makers in the setting of financial policy.
As such, the Bank of England is granted unique powers to engage with the UK’s financial system. It is a central bank, otherwise known as a monetary authority, and is the only institution with the authority to affect rates of interest. It does this in response to the impacts of policy elsewhere, where differences in economic activity can have real-world impacts for businesses and individual citizens – as we have seen recently, with the cost-of-living crisis.
The Banking System
The Bank of England isn’t the UK’s only bank, though. It is the central bank, but it does not fulfil the same role as the commercial banks with which we all engage on a daily basis. Commercial or ‘high street’ banks are intermediary parties, and private where the BoE is a nationalised entity. These private entities utilise BoE-based rates of interest to influence their own offerings – where bank accounts and loans can be considered ‘financial products’.
Savings and Investments
A key part of this ecosystem is the savings account. We all have a need for a savings pot , and banks are in a unique position to utilise this need well. Savings accounts tend to offer a higher rate of interest than other bank accounts, to entice customers to save with them; this is because savings are often left alone to grow, making them a relatively secure pot that banks can use to hedge investments elsewhere.
Commercial banks eventually absorb the BoE’s changes to interest rates, but this incorporation takes time; there are legal elements to changing the make-up of financial products, while banks also hedge against the potential for further changes to monetary policy.
Impact on Borrowers
It is the borrowing population of the UK that feel interest rate rises the most, as the amount to repay can appear to increase arbitrarily. However many borrowers do not feel the change immediately, on account of the above legal considerations but also due to the specifics of their agreement. Many mortgage holders have been spared the considerable hikes of early 2023, by virtue of being locked in a fixed-rate product. The expiry of these products poses a problem for borrowers and banks alike, though.
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