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