7.2 Setting interest rates and the role of the Bank of England
To understand what determines the level of interest rates charged when you borrow money, you first need to understand how ‘official’ interest rates are set. In Video 2, recorded in 2015, the then Chief Economist at the Bank of England, talks about the factors that are considered when official interest rates are set. The setting of interest rates is a key facet of monetary policy – and this is used to help manage the economy.
The rate set by the Bank’s Monetary Policy Committee (MPC), also known as ‘Bank Rate’, is the rate at which the Bank of England will lend to the financial institutions. This, in turn, determines the level of bank ‘base rates’ – the minimum level at which the banks will normally lend money. The result is that the Bank Rate (also known as the ‘official rate’) effectively sets the general level of interest rates for the economy as a whole.
The Bank of England’s MPC meets eight times a year to consider policy and set its Bank Rate in the light of economic conditions – in particular the prospects for price inflation (the rate of increase in the price of consumer products like groceries, clothing, household goods and fuel).
The prime objective is for the MPC to set interest rates at a level consistent with keeping price inflation at around 2% p.a. For example, if the MPC believes inflation will go above 2% p.a. it might increase interest rates in order to discourage people from taking on debt – because if people spend less, it could reduce the upward pressure on prices. Conversely, if the MPC believes inflation will be much below 2% p.a. it might lower interest rates (also known as ‘easing monetary policy’), and people might then borrow and spend more.
However, after 2013 this approach to setting Bank Rate was modified to one where the MPC takes greater account of other measures of economic activity, like the level of unemployment. The video explores this change of emphasis.
Official rates of interest tend to move in cycles, rising to peaks and then falling to troughs. Since 1989 the trend in the UK has been for the peaks in interest rates to be successively lower. The official rate of interest (or Bank Rate) set by the Bank of England fell to 3.5% in 2003. In 2009 it hit a then-record low of 0.5% and was reduced further to 0.25% in August 2016. In December 2019, Bank Rate was back up to 0.75%, only to be cut again to 0.1% in 2020 to help combat the economic consequences of the coronavirus (Covid-19) pandemic. The surge in energy and other costs in 2022, against the backcloth of the war in Ukraine, has pushed price inflation much higher. By August 2022 the annual CPI inflation rate stood at 9.9% with some analysts predicting that it will be 18% or even higher by early 2023. This development prompted the MPC to make a series of increases to Bank Rate. In August 2022 it stood at 1.75% with further increases anticipated by analysts.
Note, though, that for individuals the rate paid on debt products will be ‘at a margin’ – sometimes a very high margin – over Bank Rate and bank base rates. In other words, the rate that is actually paid by individuals will be higher. The margin added by lenders will take into account the product (particularly if the loan is secured or not) and the risks associated with the lending, including the credit worthiness of the borrower. So, while there is usually a small margin of around 2–3% between Bank Rate and mortgage rates, there is a huge margin between Bank Rate and, say, the rates on credit card debts and payday loans.
One other factor to consider is the difference between price inflation and interest rates – the difference is referred to as the ‘real’ interest rate. When interest rates are higher than price inflation, then real interest rates are positive. This is good news for savers who will see the purchasing power of their savings rising. When price inflation exceeds interest rates, then real interest rates are negative. This is bad news for savers who will see the purchasing power of their savings falling.
For anyone who is borrowing, the reverse applies – positive real interest rates are bad news, but negative real interest rates are good news.