The role of the Bank

• The Bank of England has been independent of government since 1997
• The Monetary Policy Committee (MPC) has nine members, some of whom are appointed by the government and some by the Bank of England. The Governor of the Bank has the casting vote if there is an equally split decision on interest rates
• Each month the MPC meets to consider the latest news on the UK and global economy
• Their job is to make a judgement on what is the appropriate level of base interest rates for the UK economy consistent with the need to meet an inflation target set by the government
• That inflation target is consumer price inflation of 2%
• The MPC has one eye on maintaining growth (although a set rate of GDP growth is not part of their target). Inflation is allowed to vary by 1% either side of the 2% target – so they have some leeway.

Key Roles for a Central Bank

• Monetary stability: Conducting monetary policy to ensure stable prices and confidence in the currency. Many countries have an inflation target – often set by the Government for a central bank to achieve. E.g. the UK Government sets the Bank of England an inflation target of 2%. Their aim is to keep the annual rate of consumer prices inflation (CPI) within 1% of the target. This has proved difficult in recent years with UK CPI inflation averaging over 3% since the start of recession in 2008. Inflation returned to the 2% target in December 2013 for the first time in 60 months!
• Financial stability: This means overseeing the financial system so that there is an efficient flow of savings and loans and confidence in financial intermediaries such as banks. Depositors need to know for example that their savings are safe and that banks and other lenders are acting responsibly.
• When financial stability breaks down there are damaging economic and social consequences. Consider for example the fall-out from the banking failures in Cyprus in 2013. In December 2013, it was announced that the 18-nation Euro Zone is introducing common rules and protections for its banking industry. The idea is to make multi-billion Euro taxpayer-funded bank bailouts a thing of the past. This will include a common banking supervisor and a common deposit guarantee for savers

Factors considered by the Bank of England when setting interest rates

At each of their rate-setting meetings, the members of the MPC consider a huge amount of information on the state of the economy. Here are some of the factors they consider when making rate decisions.

• GDP growth and spare capacity: The rate of growth of GDP and the size of the output gap. Their main task is to set monetary policy so that AD grows in line with productive potential.
• Bank lending and consumer credit figures - including the levels of equity withdrawal from the housing market and also data on credit card lending which supports consumer demand
• Equity markets (share prices) and house prices - both are considered important in determining household wealth, which then feeds through to borrowing and retail spending. The monetary policy committee has no official target for the annual rate of house price inflation but it has been criticized for not doing enough to prevent the housing bubble in Britain up to 2008.
• Consumer confidence and business confidence – confidence surveys can provide “advance warning" of turning points in the economic cycle. These are called 'leading indicators'.
• Growth of wages, average earnings and unit labour costs - wage inflation might be a cause of cost-push inflation so the Bank of England looks carefully at what is happening to wages
• Unemployment figures - and survey evidence on the scale of shortages of skilled labour.
• Trends in global foreign exchange markets – a weaker exchange rate could be seen as a threat to inflation because it raises the prices of imported goods and services. A strong exchange rate might bring down inflation but risk causing a deeper economic slowdown via a fall in exports
• International data - including recent developments in the Euro Zone, emerging market countries and the United States and Japan.

The key point is that the Monetary Policy Committee considers many indicators from both the demand and the supply-side of the economy.

They then have to make a judgement about what this evidence says about inflationary pressures over a two year forecast horizon.

Why do they have to look up to two years ahead? Because when interest rates are changed, it takes time for them to have an effect on aggregate demand and prices. Uncertain time lags in a world of many external economic shocks make the handling of monetary policy a difficult job!

The Monetary Policy Transmission Mechanism

It is worth remembering that when the Bank is making a decision, there will be lots of other events and policy decisions being made elsewhere in the economy, for example changes in fiscal policy by the government, or perhaps a change in world oil prices or the exchange rate. In macroeconomics the ceteris paribus assumption (all other factors held equal) rarely applies!

• There are several ways in which changes in interest rates influence aggregate demand, output and prices. These are collectively known as the transmission mechanism of monetary policy
• One of the channels that the Monetary Policy Committee in the UK can use to influence aggregate demand, and inflation, is via the lending and borrowing rates charged in the financial markets.
• When the Bank's own base interest rate goes up, then commercial banks and building societies will typically increase how much they charge on loans and the interest that they offer on savings.
• This tends to discourage businesses from taking out loans to finance investment and encourages the consumer to save rather than spend — and so depresses aggregate demand
• Conversely, when the base rate falls, banks cut the market rates offered on loans and savings and the effect ought to be a stimulus to demand and output.

A key influence played by interest rate changes is the effect on confidence – in particular household's confidence about their own personal financial circumstances.

Changes in interest rates affect:

1.Housing market & house prices:

1. Higher interest rates increase the cost of mortgages and reduce the demand for housing. This will affect household wealth and put a squeeze on equity withdrawal (where consumers borrow money secured on rising house prices)

2.Effective disposable incomes of mortgage payers:

1. If interest rates increase, the income of homeowners who have variable-rate mortgages will fall – leading to a decline in their effective purchasing power
2. The effects of a rate change are greater when the level of existing mortgage debt is high as this makes property owners more exposed to higher costs of repaying debts.

3.Disposable income of savers:

1. A rise in interest rates boosts the disposable income of people who have paid off their mortgage and who have positive net savings in bank and building society accounts
2. But if the rate of interest is lower than the rate of inflation, then the annual real return on saving will be negative.

4.Consumer demand for credit:

1. Higher interest rates increase the cost of paying the debt on credit cards and should lead to a deceleration in retail sales and spending on consumer durables especially items such as cars and household appliances which are typically bought on credit.

5.Business capital investment:

1. Firms often take the actual and expected level of interest rates into account when deciding whether or not to go ahead with new capital investment spending
2. A rise in interest rates may dampen confidence and lead to a reduction in planned capital investment. However, many factors influence investment decisions other than rate changes.

6.Consumer and business confidence:

1. The relationship between interest rates and business and consumer confidence is complex, and depends crucially on prevailing economic conditions
2. For example, when businesses and consumers are worried about the recession, an interest rate cut can boost confidence because it reassures the public that the Bank is alert to the dangers of a slump
3. Some people might take emergency interest rate cuts as a sign that the wider economy is in difficulty and hard times lie ahead.

7.Interest rates and the exchange rate:

1. The link between interest rates and movements in the external value of a currency are important to understand at AS level.
2. Higher UK interest rates might lead to an appreciation of the exchange rate particularly if UK interest rates rise relative to those in the Euro Zone and the United States attracting inflows of “hot money" into the British banking system.
3. A stronger exchange rate reduces the competitiveness of UK exports in overseas markets because it makes our exports appear more expensive when priced in a foreign currency leading to a decline in export volumes and market share.
4. It also reduces the sterling price of imported goods and services leading to lower prices and rising import penetration. If the trade deficit in goods and services widens, this is a net withdrawal of demand from the circular flow and acts to reduce excess demand in the economy.

Key points:

• 1.A reduction in interest rates and/or an increase in the supply of money and credit in an economy is called an expansionary monetary policy or a reflationary monetary policy
• 2.An increase in interest rates and/or attempts to control or reduce the supply of money and credit is called a contractionary monetary policy or a deflationary monetary policy
• 3.Over the last few decades, monetary policy has been the main policy instrument for managing the level and rate of growth of aggregate demand and inflationary pressures