The Monetary Policy Committee of the Bank of England - The Repo Rate - Case Study Example

Foundations of Finance and Investment Interest Rates The Monetary Policy Committee (MPC) of the Bank of England (BOE) decided in April to keep the Repo rate at 4.50% (BOE, 2006). Forecasts by over forty City and non-City financial institutions showed a rate lower by 25 basis points at year-end, with a median forecast of 4.25% (HMT, 2006). Interest rates on 10-year U.K. government bonds are expected to rise 10 to 15 basis points to 4.65%, some 40 basis points higher from their lowest level in January 2006 (BOE, 2006, p. 1; Economist, 2006, p. 97). Interest rates determine the cost of borrowing money. The Repo rate is the short-term interest rate at which financial institutions such as banks and building societies can borrow money from the BOE for a two-week period. The MPC meets monthly to set the Repo rate as part of its monetary policy function to control inflation. Its decision on what this rate should be acts as a signal to the money markets of how much to pay savers and charge borrowers for the use of money. The Repo rate therefore acts as the baseline for the cost of money that can be loaned to customers, which can include other banks, in the form of mortgages and overdrafts (BOE, 2005). Many households and firms, however, borrow for longer time periods and prefer to fix borrowing costs in advance, either because this helps them plan their cash flows better or protects them from the future risk of rising interest rates. This is a gamble some lenders and borrowers take, since interest rates may also move the other way. Fixed long-term borrowing or interest rates are relevant to those who want fixed-rate mortgages for housing or to firms with long-term investment plans like expanding a factory that needs some years to pay off. Long-term interest rates ranging from one to ten years are calculated simply by taking an average of forecast short-term interest rates over the desired period. Short- and long-term interest rates are closely related, but differ on the basis of MPC decisions; the expectations of how the national economy will fare; the expected future inflation rates; and how likely the MPC will achieve its inflation targets (BOE, 2005). The direction of short-term rates is easy to determine because the figure depends on the latest interest rate decision of the MPC that can either raise or lower the Repo rate. Long-term rates, however, may go either way, determined by how the economy will perform many years from now. It can happen that whilst the MPC raises the Repo rate next month, ten-year rates may go down if the market thinks such a decision will cause rates to fall in the future. Future rates depend on how reliable the market finds the MPC (Barrell et al., 2006, p. 60). In deciding to keep the Repo rate at the same level in April 2006, the MPC considered several rigorously monitored variables such as U.K. inflation (down from 2.0% to 1.8%), money supply (M4, the sum of notes, coins, and so-called broad money consisting of what is held in bank and building society accounts, grew 12% in the year to February), economic growth (in line with first quarter trend rate at 0.6%), U.K. consumer spending and manufacturing (growing steadily), asset prices (rising prices of equities and houses), the sterling exchange rate (weakening or depreciating to the dollar and the Euro), risk of higher inflation (rising due to the increase in energy and oil prices), the economic performance of the U.S., the so-called Eurozone (EU countries that have the Euro as its common currency), and Japan (inflation, exchange rates, asset prices, etc.), wage pressures (rising average real product wage balanced by lower growth of average real consumption wage; the first refers to the real cost incurred by employers whilst the second refers to the take home pay of employees), and consumer surveys on inflationary expectations (rising), a key emotional factor that influences personal decisions to either save or spend. Inflation - the rise in prices of a basket of goods and services in the whole economy - if uncontrolled is a beast the MPC wants to tame because it can damage the economy's functioning. Runaway inflation as happened in Argentina in the late 1990s makes exchange rates unpredictable, erodes trust in the currency, and causes tremendous suffering on the people whose savings are wiped out, resulting in economic instability, lower business profits, and rapidly changing prices. The U.K. uses two inflation measures: the Retail Price Index (RPI) and the Consumer Price Index (CPI). Both are similar but with minor differences in composition, coverage, and weighting of prices in the index. Since December 2003, the CPI has been used for monetary policy with a target of 2.0% on average over time (BOE, 2005). Taking all these and a few other factors into consideration, the MPC decided that a "wait-and-see" attitude and keeping the Repo rate at the same level for the sixth straight quarter, despite a small risk of a rise in inflation, was the best move (BOE, 2006, p. 7-8). Figure 1 shows the 4-year movements of the Repo rate compared with the ECB (Euro) and Fed (dollar) rates. Each basis point adjustment equal to 1/100th of a percentage point (0.01%) takes some time to control inflation by influencing the level of demand in the economy by affecting consumption, output, and employment in the short term (BOE, 2005). Exchange Rates In the next six months, the sterling exchange rate against the U.S. dollar is expected to strengthen from 0.58 to 0.55 by end-2006 and 0.53 by end-2007, whilst the sterling is expected to weaken against the Euro from 0.69 in April to 0.72 by year-end, a trend expected to last until end-2007 depending on forthcoming Eurozone interest rates changes. In comparison, sterling exchange rates from a year ago (0.53 to the dollar and 0.69 to the Euro) show a slight weakening of the U.S. economy and a strengthening Eurozone with respect to the U.K. The sterling's exchange rate index has been on a downward trend since the start of the year, reaching a range of 97.1 to 98.0 in April, signifying low currency volatility due to sterling's lack of attractiveness as a medium for short-term capital flows in currency markets, perhaps caused by the U.K.'s flat interest rate curve (BOE, 2006, p. 2). The exchange rate, an important indicator of a currency's price in the money market, measures the value of a country's currency with respect to another. The rate depends on several economic factors like domestic and foreign interest rates, demand for the country's exports and the country's demand for imports, the inflation rate, economic growth, prospects for investments, and government economic policies (BOE, 2005). What affects the supply of and demand for the sterling affects its exchange rate. Since the U.K.'s two biggest trading partners are the Eurozone (47% of U.K. exports and 36% of imports) and the U.S. (15% of U.K. exports and 9% of imports), its exchange rates are determined by sterling demand and supply conditions in these two major markets and influenced by their respective inflation, interest, and growth rates relative to the U.K. Two main factors affect the strengthening of the sterling against the U.S. dollar. The growing U.S. trade deficit signals that the country spends more than it earns, financing its expenditures through borrowings and money supply increases. This is inflationary, which explains why the U.S. Federal Reserve through its Federal Open Market Committee (FOMC) is expected to continue raising the Federal funds rate (U.S. version of the Repo rate) from the current 4.75% to 5.00% by mid-2006. On top of the budget deficit, U.S. inflationary fears are growing from oil and energy price increases and their foreseen effects on prices of goods and services. The impact of previous spikes in oil price was dampened by the U.S. economy's excess capacity, enabling it to increase manufacturing production to satisfy demand growth. This time, however, the slack has been used up, creating more inflationary pressures (RBS, 2006, p.1), in contrast with the U.K. where the economy continues to enjoy spare capacity (BOE, 2006, p. 9). Whilst the oil price increase affects both countries, its perceived inflationary impact on the U.S. is relatively greater, therefore creating a negative effect on the U.S. dollar compared to the sterling. For this reason, as U.S. inflation is projected to rise from the current 3.4%, almost double that of the U.K.'s 1.8%, and despite the relative attractiveness of the U.S. dollar for short-term capital inflows due to the rising interest rates, the U.S. dollar will continue to weaken in the currency markets in relation to the sterling due to U.S. inflationary fears. As the sterling strengthens against the U.S. dollar, it is weakening in relation to the Euro because the Eurozone is more attractive relative to the U.K. A main factor related to its size relative to the U.K. is that the Eurozone, being the U.K.'s biggest trading partner, has a considerable effect on the U.K. economy, which needs Euros to pay for its imports and earns much of its foreign exchange from exports earned in Euros. The Eurozone enjoys lower interest rates (the benchmark Euro Refinance Rate is currently 3.0% and is expected to rise by 25 basis points to 3.25% by year-end). Although inflation rate at 2.4% is higher than the U.K. target, this figure is seen as a good sign of economic recovery (Economist, 2006, p. 96). Positive economic prospects in the Eurozone, forecasted increases in exports and economic activity due to a rise in the key German manufacturing index in April, and the steady action of the European Central Bank to control inflation by raising interest rates in the near-term makes the Euro more attractive than the sterling and the U.K.'s flat interest rate regime and are expected to result in a strengthening of the Euro (Barrell et al., 2006, p. 46). Figure 2 shows the sterling's movements against the Euro and dollar until end-2007. Stock Markets The U.K. stock market continues to rise, returning 22.0% up to December 2005. Performance in the first four months of 2006 continues a two-year trend. The FTSE 100 index closed at 5,912 on 12 May 2006, a level it last reached sometime in February 2001. The U.K. equities market is expected to follow its upward trajectory in the coming year on the back of stable prices and renewed business and consumer confidence. Stock market behaviour is one of the indicators of investor confidence in the global and domestic economy motivated mainly by the prospects of future profits. The intrinsic value of any stock on which its price is based is calculated from the net present value of all future cash flows (Hirshleifer, 1958, p. 350). Therefore, expectations of future profits in the form of dividends and an increase in stock prices will lead to investments in the stock market. The FTSE 100 index peaked in December 1999 at 6,930 and bottomed out at 4,079 in July 2003 due to the dotcom bust, global terrorism, inflation fears, and a host of large-scale corporate scandals across the U.S., U.K., and Europe, after which the index began its road to recovery. In 2005, high levels of merger and acquisition activity and speculation about company buy-outs may have caused a potentially transient impact on the rise in equity prices, coupled with the market's price-to-earnings ratio (PER), one of the determinants if a market is under- or over-valued, being only a little above its average since 1990 (BOE, 2006, p. 2). Interest rates influence the decision to invest in equities if the potential rate of return from a stock is greater than bond rates. Over time, equity investments show higher returns compared to gilts, bonds, and cash, which explains why investing in the stock market continues to be an attractive proposition (Barclays, 2005). Figure 3 shows the movement of the FTSE 100 compared to the Dow Jones Industrial Average. Bibliography Bank of England (2005). Target Two Point Zero. [online] Available from: . [May 6, 2006]. Bank of England (2006). Minutes of the Monetary Policy Committee Meeting of 5-6 April 2006. [online]. Available from: [May 8, 2006]. Barclays Bank (2005). Capital equity and gilt study 2004. London: Barclays. Barrell, R., Riley, R., and Kirby, S. (2006). UK Economy Forecast. National Institute Economic Review, 196, p. 40-62. Economist (2006). Economic and financial indicators. The Economist, p. 96-98. Hirshleifer, J. (1958). On the theory of optimal investment decision. Journal of Political Economy, 66, p. 329-352. HM Treasury (2006). Forecasts for the U.K. Economy: A comparison of independent forecasts. April 2006. Available from: . [May 10, 2006]. Royal Bank of Scotland (2006). Interest and exchange rate forecasts. Issued April 26, 2006. Yahoo.com (2006). FTSE100 Basic Chart. [online] Available from: . [May 12, 2006]. Figures Captions Figure 1. Interest rates: U.K. Repo, ECB Refi, and U.S. Fed funds, 2004-2007. Figure 2. Exchange rates: Sterling against the Euro and U.S. dollar, 2004-2007. Figure 3. FTSE 100 Index and Dow Jones Industrial Average, 2000-2006. Figure 1. [Data Sources: BOE, 2006;HMT, 2006] Figure 2. [Data Sources: BOE, 2006; RBS, 2006; HMT, 2006] Figure 3. [Source: Yahoo.com, 2006] Read More