The huge impact of 10 years of falling interest rates

It has been 10 long years since the Bank of England’s last interest rate rise and in that period savers have seen their cash decimated, investors have been forced to take on more risk and borrowers, enticed by low rates, are seriously over-indebted.

Today, 5 July 2017, marks the 10-year anniversary of the last interest rate rise in the UK, when the country was a markedly different place.

On this day in 2007, the Bank’s monetary policy committee (MPC) voted to raise rates to 5.75% just before stock markets went into meltdown as the global financial crisis struck. Fast forward to today and the MPC is moving closer to its first rate rise.

In the last committee meeting, members voted 5-3 in favour of leaving rates at the historic low of 0.25% that they were cut to last August after the Brexit vote. The Bank’s chief economist Andy Haldane has admitted it got close to abandoning the ‘no change’ policy it has kept in place for a decade.

While consumers may have got used to exceptionally low rates – and 8 million Brits have never seen an interest rate rise in their adult life – it doesn’t mean it will continue, and it certainly doesn’t mean it hasn’t had an impact.

Savers

The Bank may have used low interest rates to prop up the economy but savers have felt this burden the most. A saver who put £1,000 in an instant account in July 2007 will have earned just £107 in interest but worse, when inflation is factored in, their £1,000 is worth just £878.

Over the past 10 years, the amount of money languishing in non-interest bearing accounts has risen eight-fold from £23 billion in 2007 to £179 billion today, and the average rate on instant access accounts has fallen from 3.3% to just 0.4%, according to online investment broker Hargreaves Lansdown.

Non-instant access accounts, including cash ISAs, have seen average rates drop from 5% to 0.9% over the same period.

At the same time inflation has risen 26%, eating away at the value of cash in the bank and compounding the problem.

Richard Stone, chief executive of The Share Centre, said low interest rates have been hard on savers, but inflation has been tougher.

‘For a long period there has been negative real interest rates,’ he said. ‘You put cash in the bank thinking there is no risk, but it is costing you money to keep it there because inflation is eating away at it.’

What happens next?

Savers may think a base rate rise from the Bank will be their saviour but Stone warned the link between an interest rate rise and deposit account rates rising is no longer there.

‘Banks have a lot of cash and do not need to pay higher rates to encourage deposits,’ he said.

Neither does he believe that a rate rise will constrain inflation, so the value of savings will continue to dwindle.

‘People will get paid more [in an inflationary environment] and they will put more money into the economy,’ he said. ‘There are also a number of companies kept alive by low interest rates and if these zombie companies go bust then you constrain supply so inflation rises.’

Investors

The lack of interest on cash has forced investors to take more risk than they otherwise might have, or really want to.

Laith Khalaf, senior analyst at Hargreaves Lansdown, said £1,000 invested in a UK stock market fund in July 2007 would on average now be worth £1,666, or £1,323 when adjusted for inflation. This is despite the investment being made just before the stock market crashed almost 50% in the 2008-09 financial crisis. Unlike interest rates, which had remained in the doldrums, stock markets had recovered strongly since the credit crunch, he said.

Low interest rates have had a positive impact on asset prices, said Stone, as more people turned to the stock market in search of income.

‘People have had to go to the stock market…and as a function of supply and demand, if you increase the supply then the prices go up,’ he said. ‘That has contributed to the growth in asset values and that has then been exacerbated by money printing and quantitative easing,’ referring to the Bank’s policy of pumping hundreds of billions of pounds into the bonds market in order to reduce long-term interest rates.

He added that the money printed has ‘gone into assets and through asset prices we are seeing the effect that has had’.

Stone believes investors have ‘probably’ been forced to take on more risky investments.

‘If you have a pot of savings and you are earning 0.2% in the bank, if that, and someone says put it in a FTSE All Share tracker paying a 3-4% yield then why wouldn’t you?’ he said.

What happens next?

Interest rates may rise but we won’t go back to the standard 5% rates of the past, and this will have a knock-on effect for investors.

Stone predicted ‘0.25% rises for a few months to get us back to a more normal rate’, when the MPC decides it’s time, but he said it would be a ‘new normal’.

‘There will be a new normal growth rate [for investments] too. Lower inflation, lower growth and lower interest rates will be the new normal, compared to where we were,’ he said.

‘We have had a period of social and technological change from the 1950s to the end of the 20th century that will be difficult to replicate…the idea that you are going to get regular returns in double digits is unrealistic.’

Investors will have to look at ‘real returns rather than notional returns’, he said.

Borrowers

Borrowers have been the biggest beneficiaries from record low interest rates. The typical mortgage rate has fallen from 5.8% in 2007 to 2.6% today, helping to support household incomes and the housing market, said Khalaf.

Although low rates means borrowers could have paid back their debts quicker, they have actually been encouraged to take on more debt. Unsecured loan rates have fallen and there have been fewer defaults, with lenders writing off £2.5 billion of bad loans over the past year compared to £6.8 billion in 2007.

All the additional borrowing has been at the expense of saving and last week the Office of National Statistics showed the UK savings ratio had fallen to a record low of 1.7%.

Khalaf said the ‘addictive nature of low interest rates’, coupled with rising house prices and increased university debt means people are unable to save and some are forced to rely on credit to live.

What happens next?

An interest rate hike would put the brakes on consumer borrowing but Khalaf said because of the ‘fragile debt dynamics’ in the UK, it would also make existing debt less affordable.

‘The MPC has turned more hawkish recently, and expectations of a rate rise have built up considerably in recent weeks,’ he said.

‘However, the large amount of consumer debt means that even when the Bank does finally decide to wean the UK off low interest rates, it will be a very slow and steady pace.’