Why lower interest rates might not offer much support to the UK economy

Things are looking up for the UK economy.

Although the UK fell into a recession in the second half of last year, most economists are confident that growth will return this year thanks to a stronger consumer.

The figures back them up. GDP data for January showed a modest 0.2 per cent expansion while survey data for February and March suggests this trend has continued.

Forecasts from the Office for Budget Responsibility – admittedly on the optimistic side of estimates – predict the UK will grow 0.8 per cent in 2024 and 1.9 per cent next year.

One of the main reasons why economists are more optimistic is that the Bank of England is expected to start cutting interest rates in June. Lower rates should ease the pressure on borrowers, helping to stimulate economic activity.

That’s the theory anyway. But there’s a growing argument that interest rates were not that effective in bringing down inflation over the past year.

What disinflation there has been largely reflects lower energy and goods prices as the impact of the energy price shock has unwound.

The impact of interest rates on consumers meanwhile has been nullified by the changing structure of the mortgage market, namely the rise of fixed-rate mortgages, and the surge in savings during the pandemic.

Given higher rates have not been hugely effective in taming inflation, is there any reason to think they will be more effective in stimulating the economy?

As Paul Dales, chief UK economist at Capital Economics, said: “Everyone knows that one reason why the recession was so small and short is because higher interest rates had a smaller drag on the economy than in the past. But it’s less appreciated that future interest rate cuts may not boost the economy as much either.”

The glut in savings during the pandemic actually means households have seen a net benefit from higher interest rates so far.

Data on household income covering the final quarter of 2023 showed that households continued to earn more interest on their savings than they paid out on loans. This has been the case since the fourth quarter of 2022, which Dales noted is “very unusual”.

Savers tend to spend less than borrowers, so higher rates will still impact consumer spending on the whole, but the impact is less than in previous tightening cycles because household balance sheets are markedly healthier.

While this was useful in preventing a deeper downturn last year, it may also limit the positive impacts of rate cuts this year. If interest rates on savings products fall faster than rates on bank loans, then household income will actually fall.

Consumer spending will still benefit – again owing to the differences in the propensity to spend between borrowers and savers – but the positive impact will be diminished.

One other separate factor is the timing of rate cuts relative to the US Federal Reserve.

Over the last few days strong US data has raised the prospect that the Fed will leave rates on hold for a bit longer than its European counterparts.

Jerome Powell, chair of the Fed, tried to reassure markets on Wednesday saying that hot inflation readings this year had not “materially changed the overall picture,” but with the US economy still powering along, the Fed can afford to wait beyond June before cutting rates.

If the Bank does start cutting rates in June, as markets expect, and the Fed waits a bit longer, then the pound could come under pressure. Higher interest rates benefit domestic currencies, because international investors are able to earn a higher return on their investments.

“The reality is that UK economic growth is lagging than in the US. So it is possible that the UK will be forced to cut interest rates before the US,” Chester Ntonifor, foreign exchange strategist at BCA Research said.

A weaker sterling could then put up the cost of imports for UK firms, creating more inflationary pressures. In the grand scheme of things these pressures will not be huge, but it will still be a cause for some concern.