Who Sets Interest Rates – Markets or B of E?

Readers Question: Interest rates are determined by the markets and not by the Bank of England-where’s the truth?

An interesting question.

Firstly, it is worth bearing in mind that there are different interest rates in an economy.

Bank of England Base Rate. This is the most important interest rate because it is the rate at which other commercial banks need to borrow from the Bank of England. Therefore, the base rate is an important determinant of other rates in the economy.

Generally, speaking the Bank of England is free to set base rates to achieve its target of low inflation CPI 2%+/-1. At certain times markets may pressurise the Bank of England to change rates, but largely the Bank of England is free to set rates depending on how it sees fit.

  • ERM crisis. in 1992, the government increased interest rates to 15% to try and protect the value of the £ (which was then in the ERM) However,  the markets felt this interest rate was unsustainable in a recession. Therefore, people continued to sell pounds effectively forcing the £ out of the ERM and making the UK cut rates. This is an example of market forces forcing the monetary authorities to change interest rates, but, it is relatively rare.

In the US, falling stock markets was a major factor in promting the FED to cut interest rates by 1.25%. You could argue market sentiment forced the Fed’s hand to cut interest rates so much. However, in the UK, the MPC were largely unaffected by the market sentiment and only cut rates by 0.25% also suggesting that interest rates may not be cut very much in the future.

Bank Rates

Banks are free to set their own rates for lending and savings. If base rates change then invariably they will change their Standard variable rates. However, this is not always the case. The shortage of funds in the global credit markets means that banks face an increase in the cost of borrowing. Therefore, it is likely that this year particularly, they may increase their bank rates, despite a cut in Bank of England Base rates.

There is more to it than this, but these are a few suggestions

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