Interest rate changes: five things to look out for

The reaction to whatever the Bank does with interest rates will be more interesting than the decision itself

The Bank of England is considering whether to cut interest rates on Thursday (Reuters)

What happens to interest rates

The first thing to look for this week is glaringly obvious: whether the Bank of England cuts interest rates on Thursday and whether it also starts a bout of quantitative easing to push more cash into the markets. That might appear a pretty momentous event, for there has been no change in rates for more than seven years. But actually I think the reaction to whatever it does will be more important than the decision itself.

The reason for this is that some sort of action is widely expected. It is, in the jargon, “in the market”. It is just possible that the Bank’s monetary policy committee will hold off another month. There is a decent intellectual case for doing so. You want to make a measured response to changes in the economic outlook and in particular you want to try and boost confidence.

Whatever view you take on the long-term wisdom or otherwise of the Brexit vote, there is no doubt that in the short term it has shattered business and consumer confidence. The Government is powerless to do anything about this until there is a new Prime Minister in place, and the business community is pretty scared that Andrea Leadsom – the less experienced of the two candidates – might be chosen. In any case there is a hiatus until September. The only way to bridge that gap is a monetary boost.

Thus the market expects rates to be cut to 0.25 per cent and there to be some additional boost from QE. It does not expect zero rates, at least not yet, and notes the judgement of Mark Carney that the Bank will not follow the lead of the European Central Bank and move to negative rates. But there is a huge debate going on as to whether a monetary boost will have any effect. Do companies choose to invest more because the cost of capital is slightly lower? Or is that quite a minor factor?

Investment decisions are based principally on the judgement about future profitable demand. Cost of capital affects profitability a bit but if you are looking for, say, a 15 per cent return on investment, 0.25 per cent off funding costs is neither here nor there.

What the Bank’s action might do is nudge long bond yields down a bit more, but since the 10-year gilt yield is down to 0.74 per cent, it may be the damage falling gilt yields do to company pension funds will more than offset any help it gives to funding costs.

If all this sounds nebulous, it is. That is why the reaction to whatever the Bank does will be more interesting than the decision itself. I fear it may be negative and I hope I am wrong.

What happens to sterling?

The pound is very much affected by interest rate expectations and the change in such expectations – from a rise in interest rates to a fall – has been behind the 10 per cent average fall in sterling since the Brexit vote. The big question is whether it has found a floor. So far this does not seem to have happened, and looking at previous devaluations the pound may well be weak for several months. Will it move lower this week, the start of the holiday season? Not good news for Brits heading off to the sun.

Is there investment money coming into the UK?

You would expect with a devaluation that there would be bargain-hunters looking to snap up cheap assets, particularly in property, the sector most immediately hit. This could be a once-in-a-decade buying opportunity, but only one for the brave. We are still to fine out how many brave investors there are out there.

What is happening in Italy?

The focus in Europe has now shifted from Greece to Italy. The bad news about Greece is out there in the open and while further disaster in Greece would be dreadful for the Greek people, it would not destabilise Europe. The possibility that Italy might abandon the euro would.

We are not there yet but the fact that the Italian economy has barely grown since the euro was introduced in 1999 underlines the scale of the problem. There is a referendum on constitutional reform in October. This is not about EU membership or the euro, but more than half the country says it wants on membership. Given what has happened in the UK, a shock may await.

What not to look at

Finally, not something to look for, but quite the reverse. This is British politics. It is and will remain in turmoil, and the signals that come out give no guide to the future. It will eventually settle down, but not yet. So ignore the noise.