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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 Andy Haldane, 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.

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Transcript: Video 2 The Bank of England and interest rates

Well, we’re here at the Bank of England. And Andy Haldane is the Bank of England’s chief economist. Good morning, Andy.
Good morning. Good morning.
Several questions I wanted to ask, but the first one is about monetary policy. In 1997, the government handed the Bank of England responsibility for monetary policy. Is it better for the bank to run monetary policy rather than the government?
So I think, yes. I think it’s better for the economy. I think it’s better for society. I think it’s better for the government as well, actually, for something like monetary policy to be put into the hands of the central bank.
Now, why do I say that? Well, what we found in the past in the UK, and what many other countries have found, historically, is that leaving monetary policy, interest rates, in the hands of politicians leaves it rather at the whim of elections. So the pattern we sometimes saw in the UK and elsewhere was, for example, monetary policy being loosened, interest rates being lowered, in the run-up to elections, which might not have suited the needs of the economy. It might have generated bouts of inflation, the sort of thing we saw during the 1970s and parts of the 1980s.
So emerging best practise, internationally, over that period, was to delegate responsibility for the setting of interest rates to a central bank, arm’s length from elections, from the political process. And that way, there’s less chance of stoking up inflation pressures ahead of elections.
And as best we can tell, on the basis of experience both in the UK and internationally, those countries that have handed monetary policy to the central bank have better been able to keep inflation under control. In the UK since 1987, when the bank was given operational independence for interest rate setting, inflation has averaged the target of around 2%. So I think that’s been a good outcome for the economy, for society, and ultimately it’s good for the government, as well.
You mentioned the target for inflation of 2% and how the MPC, the Monetary Policy Committee, when setting interest rates, has its eye on that. And I think now you also look at something called excess capacity within the economy, as well, and how that might impact on inflation. But what about the poor old savers? I mean, do you think about them when you’re setting interest rates? Because after all, a lot of people with savings, particularly in later life, rely on interest for income.
Yeah, absolutely we do. So when setting monetary policy, when setting interest rates, you’re right, we have an inflation target of 2% to hit. But that’s not the only thing we have a weather eye on. We also have objectives to support the economy and to support the government’s objectives for employment and growth.
So all of the time, we are looking not just at price pressures in the economy, but levels of employment and levels of activity and how our interest rate decisions are affecting both borrowers and savers. Now, of course, we can’t keep everyone happy with one interest rate. If you’re setting the interest rate low, you are benefiting borrowers somewhat to the expense of savers and vice versa when interest rates are high. What we have to do is balance those interests and ask ourselves what is best for the economy as a whole. And that’s what we do.
End transcript: Video 2 The Bank of England and interest rates
Video 2 The Bank of England and interest rates
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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.

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.


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