Previous articles have looked at the Bank of England’s bank rate. For a brief recap, the chart below plots the level of the bank rate since 1901.
When growth in an economy is thought to be too low, interest rates may be reduced to increase consumption and investment. However, at a certain stage low interest rates may lead to inflation with over-investment in property and other assets. At this point, to limit inflation, interest rates may be raised.
This cycle of interest rates increasing and decreasing is roughly related to the economic cycle: low growth leads to lower interest rates, and high growth leads to higher interest rates.
When central banks are lowering interest rates this is often referred to as the easing phase of the interest rate cycle; when rates are being raised this is the tightening phase of the cycle.
For the purposes of the study here, rates are said to be in an easing phase if the previous rate change was down. They stay in this phase until a positive rate change occurs, at which point rates move into a tightening phase.
The following chart reproduces the first chart but overlays vertical bars to highlight the tightening phase of the interest rate cycle (i.e. periods when the bank rate is being increased). The periods without grey bars are therefore easing phases.
The following table gives a summary of the length of time the base rate stayed in the respective phases.
Over the whole period rates stayed in an easing phase (68%) for twice as long as they did in a tightening phase (32%).
The following chart is similar to the above, but zooms into the shorter time period: 1970-2016.
It can be seen that before 1988 monetary policy changed direction frequently (i.e. the average interest rate cycle was short). After 1988, monetary policy settled down and the interest rate cycle became much longer.
For example, in the five years, 1983-1988, there were seven full rate cycles (i.e. an easing phase followed by a tightening phase), the same number as occurred in the 28 years since 1988.
For reference, the following chart overlays the FTSE All-Share Index on the BoE base rate.
It can be seen that the period of great credit expansion that occurred 1980-2000 was accompanied by an overall decline in interest rates from 17% to 5%.
The following chart (crudely) shows what happened to equities over this period during the discrete periods of interest rates being eased and tightened.
- The green line plots the value of a portfolio that invested in the equity market only during the easing phase of interest rates.
- The blue line plots the value of a portfolio that invested in the equity market only during the tightening phase of interest rates.
The red line plots a simple buy-and-hold market portfolio. All portfolio values start at 100.
By 2016 the Easing Portfolio had a value of 986, while the Tightening Portfolio a value of 228. Obviously some of this difference in performance is attributable to the fact that the Easing Portfolio was invested in the market for twice as long as the Tightening Portfolio.