Bank of England interest decision announced

Vital announcement for the insurance sector – the most important since the financial crisis - revealed in the last few minutes

It was built up as the most important announcement from the Bank of England since the financial crisis back in 2009 – and now the decision has been made.

At noon today, the Bank of England slashed interest rates to a new historic low of 0.25% as it attempts to stave off the economic storm that has been looming since the referendum vote and decision to leave the European Union.

The Bank had held interest rates steady at 0.5% since March 2009 and many were surprised last month when Mark Carney and the Monetary Policy Committee chose to leave interest rates unchanged stating that it had a desire to look further at the post-vote landscape before making a decision on what stimulus was needed.

However, since that time the Bank of England’s chief economist Andy Haldane and Martin Weale, the former director of the National Institute of Economic and Social Research, both outlined the need for some level of stimulus to be introduced making today’s announcement less about if the rate would be cut and more about how far the cut would go and what additional stimulus would be put forward – possibly in the form of increased quantitative easing.

Here is an excerpt from the Bank’s official statement accompanying the announcement:

Following the United Kingdom’s vote to leave the European Union, the exchange rate has fallen and the outlook for growth in the short to medium term has weakened markedly.  The fall in sterling is likely to push up on CPI inflation in the near term, hastening its return to the 2% target and probably causing it to rise above the target in the latter part of the MPC’s forecast period, before the exchange rate effect dissipates thereafter.  In the real economy, although the weaker medium-term outlook for activity largely reflects a downward revision to the economy’s supply capacity, near-term weakness in demand is likely to open up a margin of spare capacity, including an eventual rise in unemployment.  Consistent with this, recent surveys of business activity, confidence and optimism suggest that the United Kingdom is likely to see little growth in GDP in the second half of this year. 

These developments present a trade-off for the MPC between delivering inflation at the target and stabilising activity around potential.  The MPC’s remit requires it to explain how it has balanced that trade-off.  Given the extent of the likely weakness in demand relative to supply, the MPC judges it appropriate to provide additional stimulus to the economy, thereby reducing the amount of spare capacity at the cost of a temporary period of above-target inflation.  Not only will such action help to eliminate the degree of spare capacity over time, but because a persistent shortfall in aggregate demand would pull down on inflation in the medium term, it should also ensure that inflation does not fall back below the target beyond the forecast horizon.  Thus, in tolerating a temporary period of above-target inflation, the Committee expects the eventual return of inflation to the target to be more sustainable.

 The MPC’s choice of instruments is based on a consideration of their likely impact on the real economy and inflation.  The MPC has examined closely the interaction between monetary policy and the financial sector, both with regard to ensuring the effective transmission of monetary policy to households and businesses, and with consideration for the financial stability consequences of its policy actions.

The cut in Bank Rate will lower borrowing costs for households and businesses.  However, as interest rates are close to zero, it is likely to be difficult for some banks and building societies to reduce deposit rates much further, which in turn might limit their ability to cut their lending rates.  In order to mitigate this, the MPC is launching a Term Funding Scheme (TFS) that will provide funding for banks at interest rates close to Bank Rate.  This monetary policy action should help reinforce the transmission of the reduction in Bank Rate to the real economy to ensure that households and firms benefit from the MPC’s actions.  In addition, the TFS provides participants with a cost effective source of funding to support additional lending to the real economy, providing insurance against the risk that conditions tighten in bank funding markets. 

The expansion of the Bank of England’s asset purchase programme for UK government bonds will impart monetary stimulus by lowering the yields on securities that are used to determine the cost of borrowing for households and businesses.  It is also likely to trigger portfolio rebalancing into riskier assets by current holders of government bonds, further enhancing the supply of credit to the broader economy. 

Falls in interest rates are known to decrease the liabilities of an insurance company by reducing future obligations to policyholders. However, they are also known to make products less attractive, impacting sales and creating lower income from premiums. There can also be a negative impact on a firm’s risk profile as an equity investment if the company may struggle to meet future financial obligations. Lower levels of equity investment in turn mean lower levels of assets for insurers.

So now the Bank has made its move, the question will be: how does the insurance industry react?

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