What determines interest rates in the UK

• Interest rates are set by the Monetary Policy Committee, Bank of England. The MPC are independent from the government.
  
• Before 1997, interest rates used to be set by the Chancellor. It was argued, with a degree of justification, interest rates were subject to political motivation.
  
• The government now just sets the MPC an inflation target of CPI = 2% +/- 1
• The MPC aim to keep inflation as close to this target as possible.
  
• If inflation is above or below this level, the governor of the Bank of England has to write a letter of explanation to the chancellor.
• In theory, they only target inflation; however in practise they may consider the effects of interest rate changes on economic growth, unemployment, and to a lesser extent the housing market and the exchange rate.
  

Inflation Forecast

The MPC try to predict future inflation trends. If inflation is forecast to be above the government's target, they can increase interest rates to keep inflation low.

Predicting Inflation

• To predict inflation the MPC look at various economic statistics. Inflation occurs when the economy operates close to full capacity.
  
• Therefore, if economic growth is above the long run trend rate of growth, inflation is likely to occur.
• Note: in the UK the average sustainable growth rate, since 1945, has been about 2.5%. Therefore, if growth is much higher than this, it could be a signal to increase interest rates.
  
• Another guide to inflation is when Aggregate Demand (AD) increases faster than productive capacity; in this case the economy will be in danger of overheating and inflation is likely to occur.

To predict the amount of spare capacity, the MPC will look at a variety of economic statistics such as: house prices, mortgage borrowing, investment levels, exchange rates, consumer spending, consumer confidence, manufacturing output, unemployment levels e.t.c. When combined together, these statistics give an indication of inflationary pressures.

Interest Rates and Inflation.

Why Higher interest rates reduce inflation:

1. Cost of borrowing increases; therefore, this reduces consumer spending and business investment
2. Mortgage payments increase; therefore, the disposable income of homeowners falls. This causes lower consumer spending
3. Higher interest rates increase the incentive to save rather than spend.

Therefore, because higher interest rates reduce consumer spending, they reduce economic growth, and therefore reduce inflationary pressures.

Does the Bank of England Set all Interest Rates in the UK?

• No, the bank only sets the base rate (the REPO rate). This is the rate at which commercial banks need to borrow from the Bank of England.
• In practice, if the Bank of England increases the base rate, usually the commercial banks make a corresponding change in their interest rates.
• However, they are under no compulsion to do so. But, the Bank of England keeps the commercial banks deliberately short of money so they have to borrow from the Bank of England.
  
• Therefore, the commercial banks see the base rate as the real cost of money (it does start to get a bit complicated...) see more on how BofE effects interest rates
  

• Monetary Policy Committee at bank of England
• Effect of Interest Rate changes
• Effect of Rising interest rates
• Guide to interest rates
• To what extent does the housing market effect interest rates?
  

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To what extent does the Housing Market Effect Interest Rates?

Recently the governor of the Bank of England admitted UK monetary policy may have been responsible for encouraging a consumer credit boom and also boom in house prices.

With many commentators arguing house prices are overvalued (House prices set to fall) a good question to ask is why didn't the government and MPC do more to reduce the housing boom? e.g. they could have increased interest rates earlier to prevent house prices rising too much.

In short the answer is that interest rates are used to meet the governments inflation target. The housing market is not a direct objective of monetary policy.

The other reason is that the underlying reason for the rapid increase in house prices is the fundamental shortage of supply. Because demand is fundamentally greater than supply using interest rates to reduce house prices doesn't tackle the fundamental problem in the housing market.

To be fair to have prevented rapid house price inflation interest rates may have needed to be quite a bit higher, this could easily have contributed towards a downturn in the economy.

For more details See: Effect of Housing Market on Interest Rates

• UK Housing Market

UK January Inflation figures good news for homeowners

The latest CPI inflation figures released by the bank of England show that the main inflation rate was 2.7% in January. This is a fall of 0.3% on the December figures.

However the old method of calculating inflation, the RPI was 4.2%. This higher inflation figure is mainly because it includes mortgage interest payments. The latest RPI inflation figures are high because they include the recent quarter point rise in inflation.

The main downward pressures on inflation this month are from falling petrol and fuel prices. Also some communication costs and airtravel is lower than this time last year.

The effect of a lower inflation rate means that there is less necessity for an interest rate increase in the near future. With the Bank of England Governor claiming that inflation is likely to fall in the second half of the year it is even possible that the interest rate cycle has peaked.

However there are still inflationary pressures in the economy. These are coming from a resilient housing market and strong economic growth. GDP growth is currently 3% which is slightly above the long run trend rate of growth.

The Role of the Bank of England

The Bank of England performs several tasks in the UK economy.

1. It issues notes and coins. The Bank of England is the sole issuer of notes and coins in the UK. In theory you could take a £10 note to the Bank of England and ask for you equivalent sum of Gold. I don't know whether they would take kindly to such requests but in theory that is how they maintain confidence in notes and coins as a medium of exchange

2. Managing the government’s debt. National Debt in the UK At the end of 2005/6 general government debt was £529.1 billion, equivalent to 42.1 per cent of GDP. [1]
To manage the government debt the bank of England sell bonds and gilts to the private sector. Usually bonds have a lifetime of about 30 years. In order to encourage people to buy government debt they need to offer an attractive interest rate. Interest payments on UK debt amount to nearly £30 billion a year

3. Managing Monetary Policy. In particular the MPC Monetary Policy Committee is responsible for changing interest rates in order to keep inflation within the governments target of CPI 2% +/-1. To achieve this inflation target the MPC meet every month and examine future inflation trends. If inflation looks to be increasing then they will vote to increase interest rates in order to dampen demand.

4. The Bank of England actually set the base rate of “repo” rate. This is a rate at which they lend to the commercial banks. They keep the banks short of liquidity so that they often have to borrow on this repo rate. If this repo rate changes then the commercial banks usually pass the changes on to their customers by changing there own interest rates.

5.. Acting as lender of last resort. If the commercial banks are short of cash then they go to the Bank of England who will be able and willing to lend them money. This is important for the banking system because it ensures the banks are never short of cash and so people have confidence in the banking system.

6. The Bank of England oversees the banking and financial system of the UK

[1] http://www.statistics.gov.uk/cci/nugget.asp?id=277

Have interest Rates in UK peaked already?

Recent increases in the interest rate suggest that there are more increases on the way. Inflation has reached 3% which is at the upper limit of the Banks CPI inflation target. Furthermore the UK housing market appears as buoyant as ever. House prices continue to rise to record levels (£137,000+) With this backdrop of rising inflation and rising inflation it suggests that interest rates may have to continue rising.

However on the other hand the Governor of the Bank of England has suggested that he expects inflation to fall sharply in the second half of this year. Much of last months increase in inflation is due to rising energy prices and tax. When these are taken away the inflationary situation doesn't appear quite so bad. If this is the case and if house prices start to slow down the need to increase interest rates will diminish significantly.

Higher Interest Rates not so Likely

News that the recent MPC committee only narrowly voted for a rate rise, suggests the likelyhood of the next rate rise is unlikely to be up. The final vote was 5-4 with Mervyn King casting the final vote in favour of a rate rise. Mervyn King also made an uncommon prediction about future inflation. He states he believes that inflation is likely to fall in the second half of the year. - Possibly quite sharply. This will come as good news to UK homeowners as it makes future interest rates harder to justify. However there is still evidence the UK economy is performing robustly with economic growth above long run trend rate of growth.

See state of UK economy in 2007

Bank split on January vote

UK Inflation and Interest Rates both Rise

The Bank recently announced a rise in interest rates to 5.25%. This was unexpected at the time, however inflation statistics a couple of days later seemed to entirely justify their decision. CPI inflation rose to an 11 year high of 3%. By historical standards 3% is not too bad, but the Bank of England will be keen to maintain their impressive anti -inflationary credentials and avoid future inflationary pressures. Therefore the prospect for homeowners is not looking too good for 2007. Interest rates may have to rise further to reduce spending sufficiently to prevent inflation exceeding its target.

Full article: Prospect for UK interest Rates 2007


Prospect for House Prices 2007

How effective are interest rates in reducing inflation?

The main instrument of UK monetary policy is the use of interest rates, set by the MPC. The theory is that interest rates are very effective in controlling inflationary pressures. The relative success of meeting the government’s inflation target in the past 7 years suggests that this proves the effectiveness of monetary policy.
In brief raising interest rates helps to reduce Aggregate demand in the economy. When interest rates are raised several things are affected. Firstly those with mortgages have higher monthly payments, this reduces their disposable income and reduces their spending. Secondly there is an increased incentive to save money rather than spend. Thirdly those who have other forms of borrowing will be hit with increased interest repayments, it will also discourage people from buying on credit. Therefore in principal raising interest rates will reduce demand and prevent the economy from overheating. This enables inflationary pressures to be subdued.

However there are various factors which make interest rates less reliable as a means of monetary policy.

1. Firstly there is a long time lag before interest rates have an effect. People with loans will not stop their spending just because of interest rates rise. However in the future it may discourage people from borrowing and investing because of the higher interest rates. It is estimated interest rates can take 18 months to have a full effect. This is why Monetary policy is pre-emptive. The MPC try to predict inflation trends in the future and change interest rates before inflation increases.

2. Related to the last point is the difficulty of predicting future inflation trends. For example accurate information about the current state of the housing market is often difficult to obtain. If statistics about the current state of the housing market are difficult to obtain it shows how difficult it is to predict future statistics like house prices ( a cursory glance at predictions for house prices shows a wide range of forecasts)

3. Interest rates have different effects on different types of consumers. When interest rates rise, those with new large mortgages definitely feel a very painful financial squeezing. Even one quarter of a % can have a big impact on their monthly payments. However it is worth remembering that a large % of the population do not have very high mortgage payments. They have either paid off a large proportion of their mortgage or they are renting. Thus higher interest rates reduce the spending but only of a certain section of the population. Those with large savings may feel better off because they are getting higher interest payments each year.

4. It depends on consumer confidence. Higher interest rates may reduce people’s disposable income however if they are very confident about future income prospects they may not reduce there spending, confidence is a very important factor effecting consumer spending, it can have an unknown effect on UK monetary policy.

5. Higher interest rates have an effect on the £, increasing its value making it more difficult for exporters. Again this is often an unwanted side effect of monetary policy. Therefore monetary policy often has a more than proportionate effect on the manufacturing / export sector.


UK interest rates increase again

UK Monetary Policy

UK Interest Rates increase again

Why Interest Rates were increased again to 0.25%

To the dismay of householders and industry, the Monetary Policy Committee unexpectedly increased interest rates for the third time in only 6 months. Interest rates now stand at 5.25%. Although the increase was only a quarter of 1%, it will add considerable financial burden to the UK’s overstretched borrowers. For example somebody with a mortgage of £100,000 will find themselves paying an extra £15, or £21 for an interest only mortgage.

The citizens advice bureau warned of financial disaster for some families, especially since it comes in the difficult post Christmas spending period. The CBI also expressed its regret. The CBI are worried on behalf of exporters. The rise in interest rates has further increased the value of the £ making British exports less competitive. The pound rose yesterday to nearly $2 per £1. Given the impact on borrowers and increased risk of insolvency many have questioned the banks motives.

The Monetary Policy Committee have defended their decision by saying that inflation is still above the government’s inflation target. CPI Inflation is currently 2.7%. However some argue that this is only a small divergence between their target of 2%. The key thing is the future course of inflation. Next month the MPC will produce their inflation report, this could be key to deciding whether interest rates have to rise further. The MPC also cite other inflationary pressures; such as the ever-resilient housing market. House prices rose by 3.3% in the last 3 months giving another unsustainable rise. The MPC also cited increased wage pressures. The latest wage settlements have been averaging around 4%, a figure the MPC argue could lead to further inflation; the CBI however were disputing the inflationary impact of wage rises. Perhaps the most significant justification for the interest rate rise is that this pre-emptive move will prevent future interest rate rises. If the MPC can dampen consumer spending early it will prevent a future inflationary situation. This pre-emptive inflationary strategy is exactly what Gordon Brown had in mind when the MPC were made independent in 1997.

However some economists are increasingly aware of the limitations of monetary policy. The effects of raising interest rates are not equally spread across the economy. First time buyers and usually young people with high levels of borrowing will definitely feel the financial pinch. However there is a significant proportion of the economy sitting on equity gains from rising house prices, these consumers have also usually paid off most of their mortgage. Therefore higher interest rates do not dampen their spending. In fact the elder generation are often helping out their children with equity for buying a house. This and the influx of foreigners into the housing market is maintaining healthy demand despite the increased interest rates. The effect of this is that rising interest rates may have less impact on reducing inflationary pressures. Increasing the likelihood of future inflationary pressures.

Effect of Rising Interest Rates in UK

The Future of Interest Rates in UK (Nov 2006)

UK Interest rates at BBC