The Bank of England Monetary Policy Committee (MPC) is responsible for setting interest rates and trying to achieve a target rate of inflation.
Until 1997, the government set interest rates and monetary policy. But, it was felt that the government might make bad decisions because they would be influenced by short-term political pressures. Therefore, they decided to give the Bank of England independence.
The Bank of England Role
- The Bank of England is responsible for setting base interest rates. This tends to influence all interest rats in the economy.
- The Bank can also influence the money supply, e.g. pursue quantitative easing (e.g. 2009-22)
- It does not directly set mortgage or loan rates — banks do that themselves.
- It does not set fiscal policy (taxes or government spending) — although QE has influenced fiscal policy in recent years (see end)
- From 1997 to 2008 inflation was relatively stable.
- In 2022/23, inflation rose considerably above the government’s inflation target of 2%.
In theory, the government still retain some control over the Bank of England, but in practise, they have little or no influence over the Bank’s monetary policy.
Independence of the Bank of England
- In the UK, the Monetary Policy Committee has independence in setting interest rates.
- The government appoint members to the MPC. In theory, they could appoint members who are more sympathetic to the ‘government’s point of view’. In practice, they don’t. Nor do the government threaten to remove members for choosing a certain monetary policy.
- The government set the inflation target currently CPI = 2% +/- 1. In theory the government could change the inflation target or remit of the MPC. In practise, they haven’t. If there was a serious economic shock. e.g. rising oil prices causing cost-push inflation (stagflation – rising inflation and rising unemployment) some governments may be tempted to raise the inflation target from say 2% to 4%. In effect, this is telling the MPC not to increase interest rates. In practise, I think governments would have difficulty getting away with this. – Markets would soon lose confidence in monetary policy. Also, the Bank of England has often decided to accept a higher inflation rate rather than risk lower growth.
- The Government could threaten to change fiscal policy. For example, if the MPC keep interest rates higher than the government wants. They could threaten to use expansionary fiscal policy. – Cut taxes and increase spending. In practise the government hasn’t done this.
- The letter of explanation. If inflation misses the government’s target by more than 3% or less than 1% they have to write a letter of explanation to the chancellor. The MPC has always sought to avoid this. However, in theory, the MPC could ignore the government’s inflation target and just write letters saying we are sorry inflation is too high. Although I doubt the MPC would do that.
- Between 1997 and 2007, economic conditions were relatively benign. The government have been quite pleased with the economic situation. Therefore, they have felt little need to interfere with the operation of monetary policy. However, after 2007, the MPC have had a more difficult balancing act with higher cost-push inflation and lower growth.
How the Bank of England Affects Government Fiscal Policy
A complication is that in 2009, the Bank of England began quantitative easing – this involves creating money to buy bonds. This reduces bond yields
In the initial phase of quantitative easing, the Bank of England made a net profit from quantitative easing. But, after quantitative easing was reversed. Bond yields rose and so the Bank of England were making a loss which is covered by the Treasury. this damaged the UK’s fiscal position.
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Do you think that a cut in the interest rate will cause a depreciation of the exchange rate in the UK?