How Does the Bank of England Set Interest Rates?

Readers Question: How Does MPC set interest rates.

Yesterday, the nine members of the MPC voted to keep base interest rates unchanged at 5%. What explains their decisions to change rates?
The MPC have an inflation target of CPI 2% +/- 1 set by the Government. Therefore, predictions of future inflation are the most important factor in determining interest rates.

To predict inflation trends they can look at several things.

1. Economic growth compared to the long run trend rate of growth. If growth is above long run trend rate, then Aggregate Demand will be increasing faster than Aggregate Supply and this causes demand pull inflation. If growth is forecast to rise above a ’sustainable rate’ the MPC are likely to increase interest rates. At the moment, growth is slowing down, demand pull inflation is relatively subdued
2. Cost push inflation. Rising oil prices and food prices cause cost push inflation. This is the real problem at the moment. Rising oil prices are causing rising transport prices, rising energy prices and increasing food prices. In fact, it is argue that CPI underestimates the real inflation because CPI exclude some of these factors. Cost push inflation is more problematic because cost push factors will be causing slower growth. To reduce inflation the MPC needs to cut interest rates. But, this will make the slowing economy even worse. Therefore, there is a trade off, the MPC can reduce cost push inflation but, it will be at the cost of rising unemployment and slower growth.
3. Wage inflation. Rising wages can cause both demand pull inflation, and higher cost inflation. At the moment, wage inflation is relatively subdued.
4. Exchange Rate. A depreciating exchange rate might cause inflation (rising demand for exports and increasing price of imports) therefore, the MPC might be inclined to increase interest rates. Furthermore, the higher interest rates may help to boost the currency.
5. Consumer confidence
6. House prices - falling prices reduce consumer spending
7. Unemployment. rising unemployment should reduce inflationary pressure
8. Manufacturing output
9. Levels of investment and levels of spare capacity

At the moment, the MPC is being pulled in two ways. Inflation is increasing because of rising oil prices. But, the economy is slowing down because of the credit crunch and falling prices. They have weighed the two up and decided to just leave things as they are. They probably hope that the slowing economy will reduce inflation in the future and therefore they may be able to cut rates later in the year.

However, it is interesting that the MPC have a target only for inflation. The Fed reserve have a target for both low inflation and higher growth. Some argue the MPC focus too much on inflation and actually should be cutting rates to avoid the real prospect of recession.

See also: Interest rates explained

• Predictions of interest rates