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Article contributed by Peter Upton
Short-term interest rates in the UK have been set by the Government for many years. Indeed throughout the twentieth century setting the level of short-term interest rates was one of the main weapons used by successive Governments of every political hue to regulate or manage the economy.
In 1997 the new Chancellor of the Exchequer (Gordon Brown) took the momentous decision to give up this tool and cede it to the Bank of England. Its brief was to control UK inflation. However, interest rates do much more than that.
Lower interest rates are good for borrowers and higher rates are good for savers. Savers tend to be the wealthy and the elderly and borrowers tend to be younger individuals and businesses.
When interest rates are low, businesses are more likely to borrow to invest in new machinery or to buy up other businesses. This is because interest is a major cost and thus a considerable factor in whether a project will be sufficiently profitable to justify the risk of undertaking the project.
The most important thing about interest rates, however, is the direction in which they are heading or rather the direction in which they are perceived to be heading. Throughout the 1990s and the early part of the 2000s the trend in UK interest rates was downwards. Until recently the perception was that the trend was continuing. However, a number of things have happened in the world economy to make businesses reconsider their perception.
Firstly in the United States, the world's biggest economy, interest rates have started to rise for the first time in twenty years. Secondly in Japan, the world's third largest economy, interest rates have risen recently from zero, which has been their rate for ten years. Then European rates have started to rise for the first time since the introduction of the Euro. All these movements will have the effect of forcing down the exchange rate of the pound against these currencies. The most immediate impact you will see is that you get less euros or dollars when you go on holiday. The next impact will be that the prices of imports will start to rise and the rate of inflation will edge upwards.
The Bank's response to a rise in inflation will be to increase short-term interest rates. Confidence in the economic prospects will be reduced which could begin a spiral, which will reverse the progress we have made over the last fifteen years.
I believe that the jury is still out since the weakness of the dollar has been a factor in the rise of US interest rates and commodity prices and thus many of our imports are priced in dollars. This will mitigate the inflationary effects for the UK. Interest rates could move in either direction.
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