UK Base Interest Rate
The notions of interest rate and exchange rate are interconnected and vitally important for the economies of different countries. To better understand the meaning of interest rate increase for the dynamics of the exchange rate it is first of all necessary to define and realize what both terms mean. So, interest rate, as defined by Arnold (2004, p. 96) and Blake (2000, p. 119), is the rate of return established by the Central Bank or Treasury of a country for investors that put their funds into local bonds or currency.
Accordingly, if the UK base interest rate is concerned, one should understand the term as the minimum interest rate established by the Bank of England regarding the investors’ decisions to invest, or not, in non-Treasury securities. At the same time, Arnold (2004, p. 359) defines the exchange rate as “the price of one currency in terms of another”, which means that the interest rate established by the Central Bank is all about the risks associated with investing in that currency, and the higher the interest rate is, the higher is the demand for the currency in question.
Base Interest Rate and Exchange Rate
Thus, the above general notions allow understanding that the interest rate in the UK, as well as in any other country, is directly connected with the exchange rate of the currency of the UK, i. e. Pound Sterling. In case if the interest rate risk (as defined by Arnold (2004, p. 369), it is the risk of adverse impacts of interest rate changes) is not observed, the increase of the interest rate in the country is proportionately related to the increase of the value of this country’s currency.
For a better understanding of the interrelation between the interest rate and the exchange rate, it is necessary to take the scenario in which the UK base rate is increased from the current level of 0.50% to 1.50%. Being interested in the effects of such a change for Pound Sterling exchange rate regarding the U.S. Dollar and Euro, it is also necessary to consider the current exchange rates for both currencies (Bank of England, 2010):
- Pound Sterling = 1.17429976 Euros
- Pound Sterling = 1.5051 U.S. dollars
So, now that all preliminary data are in place, it is possible to project the increase of the UK base interest rate upon the foreign exchange rates and, most importantly, upon their implications for foreign trade and business relations. Accordingly, if the Pound Sterling – Euro relation is taken first, it is possible to see that the increase of 1% in the interest rate will allow the value of the Pound Sterling to rise to the point of 1.27429976.
In simpler terms, the 1% increase of the UK base interest rate will require EU partners of the United Kingdom to collect more Euros in order to buy the same amount of the British currency. The implications of such an increase in the UK base interest rate are considerable, and a sample foreign trade transaction can illustrate those implications rather vividly.
Let us assume that the United Kingdom sells goods to the EU countries annually for the sum of £20,000, provided the interest rate is 0.50% and the exchange rate is 1 Pound Sterling = 1.17429976 Euros. Accordingly, if the interest rate rises to 1.50%, the exchange rate becomes 1 Pound Sterling = 1.27429976 Euros, and the sum that EU countries have to collect in Euros also increases as follows:
- Before increase: £20,000 x 1.17429976 = €23,486
- After increase: £20,000 x 1.27429976 = €25,486
Thus, it can be seen that even the slightest increase of the UK base interest rate can seriously affect the foreign exchange rate of Pound Sterling and have even broader effects on the sums of UK benefits from international trade. In the above-presented example, the 1% rise of the interest rate causes the increase of Pound Sterling value for €0.10, which increases the sum retrieved by the UK government from its hypothetical transaction with EU for €2,000.
If one takes into consideration that the sample transaction is a small-scale one and traditional international trade transactions operate with tens of millions of Pounds Sterling and Euros, the effect of the interest rate increase will become even more obvious.
A similar picture can be seen if the above discussed 1% increase of the UK base interest rate is projected on the exchange rate of Pound Sterling to the U.S. Dollar. Given the current interest rate at the level of 0.50%, the exchange rate is 1 Pound Sterling = 1.5051 U.S. dollars, while at the increased 1.50% interest rate, the exchange rate becomes equal to 1 Pound Sterling = 1.6051 U.S. dollars. The implications of such a rate dynamics for the international trade between the UK and the USA are obvious if one takes the similar hypothetical transaction of £20,000:
- Before increase: £20,000 x 1.5051 = $30,102
- After increase: £20,000 x 1.6051 = $32,102
Thus, the U.S. dollar transaction will also bring the UK government a surplus of $2,000 if the base interest rate is increased and the exchange rate of Pound Sterling rises proportionately. Drawing from this, the process of increasing the base interest rates might be a good policy to boost the demand for the currency of the country and its value as a result of the ideal market conditions. At the same time, such an ideal environment when everything develops similarly to the projections by the Central Bank or Treasury is observed rather seldom.
So, if the inflation in the country exceeds the established target level or any macroeconomic factors influence the credibility and the international value of the currency, the increase of the interest rate might result in the interest rate risk, i. e. the adverse effect on the increasing policy. A simple example might be the global economic recession, which was not forecasted and affected all major economies.
The effects of an interest rate increase in such conditions might include the failure of interest rate to boost demand for and value of the currency and the outflow of the investment from the country provided the macroeconomic conditions dictate not investing into this country’s economy even though the interest rates are quite attractive. Accordingly, the Bank of England should implement risk aversion policies before increasing the interest rate by 1%.
UK Interbank Money Markets
An interbank money market is one of the essential features of modern global economics. As argued by Gitman and Joehnk (2008), interbank money markets serve as certain intermediary units between the central banks and individual banks and organizations in the local, i. e. within the borders of a country, and international stages (p. 283).
The variety of market players and inconsistency of values for similar bonds and securities as attributed to the latter by different banking establishments have made the British Banker’s Association develop the unified standard for all interbank money markets’ players, which is called LIBOR (the abbreviation standing for (London Interbank Offered Rate). This standard brought unity and clarity into interbank money markets’ operations, although it is relatively new (established in 1984, but effectively used since 1986) (Bank of England, 2010; Liberated, 2010).
The final element of the interbank money markets is the base interest rate established by the Bank of England but often exceeded or reduced by some particular banks. Thus, the dynamics of the UK interbank money markets between 1st April 2005 and 31st March 2010 can be characterized in terms of LIBOR rates observed and Bank of England base interest rates established.
Thus, to start the review of the UK interbank money markets’ dynamics for the above-mentioned period, it is necessary to first all trace the changes of base interest rates that the Bank of England established for the country between 2005 and 2010. Next, the LIBOR rates for the mentioned period will be presented in their entirety. The comparative analysis of both major factors’ dynamics will allow making conclusions about the market development trends. Table 1 illustrates the dynamics of base interest rate changes in the UK:
Table 1. UK base interest rates, 2005 – 2010
|Year||Base Interest Rate|
|2007||5.50% – 5.75%|
Thus, the above table allows seeing that the interest rates in the UK grew up to the global economic recession that hit the markets on the merge of 2007 and 2008. However, when the economic problems began the Bank of England saw the danger of high-interest rates and reduced them twice in 2008, first to 3% and then to 2%. Such a reduction can be one of the means that helped the UK quickly overcome the effects, and avoid the severe pains, of the credit crunch and the bank crisis as far as low-interest rates attracted customers to banking establishments and saved them from bankruptcy. Further on, the levels of LIBOR for the period between 1st April 2005 and 31st March 2010 also display they’re being affected by the local and global economic developments (Bank of England, 2010).
Table 2 illustrates the dynamics of LIBOR rates change between 2005 and 2010 and allows comparing the actual interest rates with LIBOR rates for similar periods. The analysis provided further allows seeing the implications of base interest rates and LIBOR levels for the UK interbank money markets’ developmental processes:
Table 2. LIBOR changes, 2005 – 2010
Thus, the above tables (Table 1 and Table 2) reflect the dynamics of the UK interbank money markets between the 1st April 2005 and 31st March 2010. Interestingly, the growth of the base interest rates in the UK was accompanied by the growing rates of 1-year LIBOR as established by the British Bankers’ Association. Thus, the base interest rate grew from 4.50% to 5.75%, while the LIBOR grew from 3.71% in April 2005 to 5.44% in January 2008. Such figures allow arguing that the time between 2005 and early 2007 was the time of economic growth, while interest rates started to get out of regulatory control (Liborated, 2010).
The global economic recession that hit the markets on the merge of 2007 and 2008 can be thus seen as the result of unlimited interest rate increases. Faced with the recession, the Bank of England started reducing interest rates to fight the credit crunch and bank crisis effects, and this policy was accompanied by LIBOR rates decrease. For instance, between 2007 and 2008 the base interest rate fell from 5.75% to 2%, while the LIBOR figures decreased from 5.44% to the lowest point of 2.70% in March 2008 (Liborated, 2010).
Finally, when the base interest rate achieved its optimal point at the moment, i. e. 0.50%, in 2009, the Bank of England stopped the depreciation, while the LIBOR rates still had to be lowered. This was reflected in the decrease of 1-year LIBOR from 2.12% in March 2009 to 0.84% in March 2010; moreover, there is a tendency for the further LIBOR decrease in the coming months. Drawing from this, it can be seen that the development of the interbank money markets in the discussed period was controlled by the Bank of England and BBA, and their joint effort resulted in the positive market developments observed since late 2008 (Liborated, 2010).
So, the policies of the Bank of England and BBA have allowed the UK to overcome the global economic recession effects and reduce the inflation rates that had started growing in 2008. The reduction amounted to 0.7%, which is a proper result for such a short period of time. More specifically, the inflation in the UK fell from 4.1% in 2008 to the current level of 3.4% as the Bank of England reports (Bank of England, 2010).
Single Security Graph
One more essential point in studying economic phenomena and processes is the ability to create and operate with graphs and data they present. Below, a single security graph for TESCO Company is provided with the data regarding the security prices of this company in the period between 1st April 2009 and 31st March 2010 (Bloomberg, 2010):
Thus, the above-presented graph of security mid prices of TESCO Company for the period between 1st April 2009 and 31st March 2010 presents at least three interesting economic implications.
First of all, the period from April 2009 to October 2009 was the period of permanent security price fluctuations for TESCO. The securities’ prices went from 350 to 325, then from 355 to 379 and again back to 355. By October 2009, the price reached its maximum of 400 but then fell to 370 again. These fluctuations can be viewed as the reflections of market uncertainty that was observed after the peak of the global economic recession was already in the past but investors were not sure about the market stability (Bloomberg, 2010).
Second, from October to December 2009 the prices for TESCO securities grew drastically and reached the level of 438, while in October they amounted to 375 only. The first months of 2010 again brought the uncertainty of investors into the spotlight, which was reflected in security price decrease to the mark of 410, but March proved to be the beginning of the third stage.
The latter is characterized by the perfect stability of prices, which allows calling March the months of the highest rate of stability for Tesco for almost a year between 1st April 2009 and 31st March 2010. The figure for March 2010 displays that the market of securities is acquiring its stability and investors return to their common practices with reliable companies like TESCO (Bloomberg, 2010).
Interestingly, the mid-line price for TESCO securities in the given period was only slightly smaller than the highest price observed on 8th March 2010, i. e. 435.45 and 440.25 respectively. The lowest security price, 323.50, was observed on 15th April 2009, while the average price for TESCO securities between 1st April 2009 and 31st March 2010 was 390.27, which is far lower than the midline or prices as taken for March 2010 exclusively. Thus, the graph presented above allows seeing that TESCO Company recovers from the consequences of the global economic recession, and prices for the company’s securities grow in reflection of this fact.
Arnold, G. (2004) The Financial Times Guide to Investing, The Definitive Companion to Investment and the Financial Markets. FT Prentice Hall.
Bank of England. (2010). Monetary Policy Committee Decisions. IRD. Web.
Blake, D. (2000) Financial Market Analysis. McGraw-Hill.
Bloomberg. (2010) Bloomberg Professional. BPN. Web.
Gitman, L. and Joehnk, M. (2008) Fundamentals of investing. Pearson Education Inc.
Liborated. (2010). Historic LIBOR Rates. HLR. [online] The #1 Online LIBOR Resource. Web.