Last week, we saw the Bank of England give another warning that interest rates could soon be on the rise. The weaker pound is making goods we import more expensive, which is in turn increasing inflation. One of the roles of the Bank of England is to steer inflation to a target level which is set by the government – currently this is 2% and a common way of meeting this goal is to adjust interest rates.
So just what happens when the Bank of England increase interest rates – and why does it have such a profound effect?
It rewards saving.
Higher interest rates mean that consumers are more likely to save rather than spend. As retailers compete more aggressively for those consumers who are still willing to spend, prices fall and so does inflation.
The value of the pound rises.
Saving money in the UK, or investing in Pound-based debt, suddenly comes with a higher interest rate. This makes it more appealing for investors globally, so they start buying Pounds to invest. As there’s a fixed number of Pounds in circulation, this new demand pushes the value of the currency higher.
Company valuations change.
If £1 buys you US$1.25, and a UK company operating in the USA makes $1000 on a deal, that equates to £800. Now, if the value of the pound increases because interest rates are rising – so £1 buys US$1.50 – that same $1000 is now only worth £666. The overseas profits are less valuable.
Dividends become less valuable.
The prospect of a 5% dividend yield on a big company share is seen by many as more appealing than the 0.5% interest you might be paid on money deposited at your bank. Companies are aware of this so will commit to paying high dividends in a bid to keep their shares in demand – and the share price high. Some companies even borrow money to maintain the dividend, which is easier to justify when it’s inexpensive to do this. As interest rates rise, it becomes more attractive to take that yield from savings accounts, so share prices may suffer.
Interest rate rises aren’t however universally bad for businesses and one sector that typically stands to benefit is financial services. These businesses typically have a lot of cash sitting around, so even just a small increase in the amount of interest they can earn will have the potential to translate into a big boost for profits. Higher interest rates also mean borrowing costs can increase, so banks will have the potential to make more money off credit cards and loan repayments. The message from the Bank of England remains that interest rate rises will be very gradual over the next few years, but the decade of very cheap borrowing does seem to be coming to an end.