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Making sense of the base rate cut

by
01 September 2016, at 1:00am

Dylan Jenkins examines the implications of the Bank of England’s landmark decision to bring a record low to the UK interest rate

AT ITS MEETING ENDING 3rd August 2016, the Bank of England’s Monetary Policy Committee (MPC) voted for a package of measures designed to provide additional support to growth and to achieve a sustainable return of inflation to the target. Most notably, this package comprised a 0.25 basis point cut in Bank Rate to 0.25%. This is now a record low for UK interest rates and the first cut since 2009.

The Bank of England also signalled that rates could go lower if the economy worsens. The Bank announced additional measures to stimulate the UK economy, including a £100 billion scheme to force banks to pass on the low interest rate to households and businesses. It will also buy £60 billion of UK government bonds and £10 billion of corporate bonds.

How will the changes affect you? 

The base rate changes will have an impact on mortgages, savings and exchange rates. Here’s a brief synopsis of what I feel the effects will be: 

  • Some mortgages will get cheaper. Around 1.5 million homes are on tracker mortgages, and these should drop, though fixed rates won’t change and with others it’s not clear-cut. 
  • It’s more bad news for savers. Savings rates have been very low for years and are now likely to fall further, although if you’ve a fixed rate account you’re protected for the time being. 
  • The pound has fallen further. In the immediate wake of the announcement we saw a further drop in sterling – the pound already bought fewer euros and dollars following June’s Brexit vote. 
  • If you’re close to cashing in a private pension, there may be an impact. I feel that those planning to convert a pot of pension cash into an annuity (an income for life) are likely to face lower payouts as a result of the lower interest rate.

Will the changes improve the UK economy? 

Many financial analysts don’t believe this recent interest rate cut will help the economy. Savers have already glumly accepted they are earning next to nothing on their cash, and a quarter of a percentage point less interest isn’t going to persuade many to suddenly go out and spend their savings thus stimulating the economy.

In fact, and somewhat perversely, if you are relying on savings interest to cover expenditure needs, lower rates mean you need to save more – exactly the opposite of what the Bank of England wants you to do!

Likewise, the cost of borrowing is already low – marginally lower rates aren’t going to persuade individuals and businesses to ignore all the uncertainty and borrow to invest.

I believe the main message to take from the interest rate cut is that ultra-low rates are here to stay for the long term. It now seems highly likely that rates are not going to rise for at least the rest of this decade, and possibly longer.

In reality, investors are going to have to get used to earning very little on their cash savings for much longer than they ever thought. The inevitable consequence of this is that investors in search of a return on their capital are being forced into riskier assets. After all, money is very much like water – it always flows somewhere.

It is my view that the next destination for many people fed up with ultra-low savings rates may have to be to look at the possibility of a stock market-related investment – and in particular funds that provide an attractive yield, although individuals’ appetite for risk must obviously be taken into account. Sectors such as multi-asset income and equity income certainly spring to mind in this regard.

For instance, the gap between the yield available on an equity income fund (generally between 3-5% per annum) and the interest available on cash is now larger than at any other point I can remember.

In summary, more and more investors and savers happy with the additional risks of investing will have to consider turning to dividends for their income needs, once they have built up a sufficient cash buffer to cover emergencies.

However, how does this relate to the investor in search of growth? History has shown that the majority of long- term stock market returns has come from dividends. The compounding effect of re-invested dividends is an enormously powerful way to grow wealth over the long term, which is why many believe that income funds can often make a very attractive proposition for capital growth objectives also.