Investment and the Bank of England

While the Bank of England elected to maintain the 0.25% base interest rate, there’s been consistent speculation over a rate cut from the Bank of England (BoE) – from 0.25% to 0.10%. This comes in light of a lot of doubts over central bankers’ dwindling powers, particularly in the face of some of the more unique features of the contemporary global economy: the rise of cryptocurrencies and fintech, global low central-bank rates, the broaching of the 0% lower bound, questions relating to the breakdown of the Phillips Curve (which describes the inverse relationship between inflation and unemployment), etc.

The post-Brexit environment presents two key difficulties for the BoE. First, investment is depressed due to the political/institutional uncertainty surrounding the triggering of Article 50 and the lack of clarity surrounding the potential Brexit deal. Second, the pound’s value is depressed due to the same concerns. This means the elasticity (responsiveness) of both investment and exchange-rate value to base rate will be significantly reduced when compared to normal periods.

The aspect of this that tends to be overlooked on the academic side is what this means for the individual. Base interest rates near 0 penalise savers, although those heavily invested in stocks tend to benefit (the effects of negative rates are even more pronounced, but the BoE governor has – so far – distanced himself from these). With cash ISAs often making up a disproportionate amount of savers’ investments (particularly among the less well-off), extended periods of very low interest rates exascerbate monetary policy’s distributional and political effects. It is very likely that this is one of the (admittedly many) causes of the pronounced dissatisfaction with the UK government, as well as the divisions within Labour.

The low value of the pound, relative to other currencies, on the other hand, is something that directly factors into the academic literature on central banking. For consumers, the pound’s drop since the Brexit vote has led to a significant increase in the real cost of living (probably 10-20% depending on the basket of goods). When combined with minimal returns to savings and investments, this could be viewed as an important determinant in the testy battle over Labour’s leadership.

And all of this to promote investment? Well, exports respond positively to a weak currency, but I wouldn’t hold my breath over investment doing the same in this case. Because the lack of new investment is driven uncertainty over unresolved issues, much larger economic incentives would be required to persuade risk-averse investors that Britain is safe for further investment. In view of this, avoiding base-rate reductions on the BoE’s part is the right move. What happens next is dependent on how the UK economy responds (probably not much) and how the Brexit negotiations continue to unfold.

Investment and the Bank of England