Base Rates - Essay Example

Base Rates Introduction For any economy to succeed and remain healthy it needs a firm financial system. It is important for the public to have confidence in the safeness and stability of an economy’s financial system. A stable financial system is not easily disrupted by problems that may occur in particular zones of the economy. Fiscal and monetary policies are helpful in economy stabilization and inflation control (Lipsey& Chrystal, 2007). Increasing prices of goods and services generally reduces a country’s money value. It is with an aim of safeguarding the value of money and providing a framework that enables economic growth that monetary policies are formulated and implemented. The policy therefore much influences the interest rates that are applied in the country. In the U.K., The Bank of England is responsible for the maintenance of stability of the kingdom’s monetary and financial system. This it does in many ways. One role of the Bank of England is to set the base rate. This it sets as the lending rate to the institutions of finance in the U.K. As UK’s central bank and the chief lender, the Bank of England loans money to the other institutions of finance including banks in the U.K. The benchmark upon which it lends money to the banks is known as the base interest rate. The banks then use this interest rate as the foundation upon which they peg their interest rates to borrowers and the general public. How the Process Works In the Bank of England is a Monetary Policy Committee (MPC) that has the responsibility of maintaining price stability by setting and smoothing the interest rates (Cobham, 2003). The committee’s other objective is to support the government’s economic policy that may include objectives for employment and growth (Russell & Heathfield, 1999). The MPC, which is made up of nine members uses the inflation target to enable it to set the base interest rate. All the members of the MPC are experts in monetary policy and economics who are independent as they do not stand for individual areas or groups (Bank of England, 2007). Each committee member has a vote that is of equal weight with the decision being reached upon on the principle of one man one vote. The MPC meets on a monthly basis to set an interest rate. The Bank of England staffs provide briefings about the economy to the MPC throughout the month. One of these briefings includes a meeting lasting for half a day on the Friday before the day of the interest rate setting. In this meeting MPC members are availed and explained to the most recent data about the economy, trends and analysis of issues relevant to the economy. Also made available is data on the business situations around the U.K. from the agents of banks The monthly meeting goes on for two half-days consecutively. Day one is for updates on the recent economic data and selection of issues for discussion. Day two is for provision of the previous day’s summary and discussions whereby all members explain views on what the policy should be (Fry, Dickinson & Allen, 2002). After the discussions, the governor puts up a policy that reflects the views of the majority and a vote is made. A member of the minority vote is asked to say what base interest rate he or she would have preferred. This is noted down in the meeting’s minutes. Still on the second day of the meeting, the decision on the base rate is made public at noon. The MPC afterwards explains its decisions and how they were arrived at. The minutes of their meeting are also published a fortnight after the decision on the base interest rate. The minutes are usually detailed on all that took place at the meetings including all the individual views, differences in opinions and the individuals’ votes. How base rate is used to influence the term structure of interest rates. The interest rates’ term structure is frequently mentioned especially as an indicator of policy stance or as a market expectations indicator (Estrella &Mishkin, 1995). Term structures contain important data on inflation and future real activity market expectations. Central banks have the ability to influence term structures but not control it completely. Term structures are measured using the difference between short term and long term interest rates of the government (Gunsel & Cukur, 2007). Return differences between Treasury Bills and long term government bonds capture the influence of the interest rates’ term structures. The relationship between maturity time of a debt and the interest rate for a certain currency and borrower is known as the yield curve. An increase in the Central Bank’s base rate has a flattening effect on yield curves, even though the spread of the yield curve has the tendency of falling by less the increment of the base rate (Estrella &Mishkin, 1995). The long rate increases with increase in the base rate though by a lesser value than the short rate. The extent of the yield curve flattening due to the central bank’s base rate seems to be connected to the credibility attached to the move of the central bank. Importance of Base Rate Knowledge about the base lending rate of the Bank of England can be very handy for anyone who is interested in investing in England. An investor, who lends his money to a borrower, say a bank, can be able to calculate how much he will get back depending on the base interest rates. The base rate given by the Bank of England also determines greatly the interest rate by which the retail banks will give loans. Knowledge of the base rate therefore can equip one with the knowledge of the best time and the worst times to invest in a market or even apply for loans in the retail banks. Conclusion The Central Bank of England is charged with the role of setting an interest rate that will; keep inflation low. The bank, apart from setting the base rate and issuing bank notes, also ensures that the Kingdom’s financial system is stable. It assesses potential risks that the financial system faces and takes measures to strengthen the way it (the system) operates. In other words, it must ensure that prices of goods and services are stable, inflation is low and that people are confident with the currency. One way it does this is by setting the base rate which impacts interest rates applied by financial institutions in the country. References Bank of England (2007) How monetary policy works, retrieved http://www.bankofengland.co.uk/monetarypolicy/how.htm (Viewed 13th December, 2009). Bank of England (2007) Monetary Policy Committee, retrieved http://www.bankofengland.co.uk/monetarypolicy/overview.htm (Viewed 13th December, 2009). Cobham; D. (n.d.) Why does the Monetary Policy Committee Smooth Interest Rates? Oxford University Press. Estella;A., and Mishkin;F.S. (1995). The term structure of interest rates and its role in monetary policy for the European Central Bank. Federal Reserve Bank of New York Research paper no. 9526. Fry; M.J., Dickinson; D.G.,and Allen;B.(2002). Monetary policy, capital rates: essays in honour of Maxwell Fry. Vol. 13. Routledge. Guncel; N. and Cukur; S.(2007). “The effects of macroeconomic Factors on the London Stock Returns: A sectoral Approach”, retrieved http://209.85.229.132/search?q=cache:oX2Hd13IDxcJ:www.eurojournals.com/irjfe%252010%2520nil.pdf+influence+of+the+term+structure+of+interest+rates+in+UK&cd=10&hl=en&ct=clnk&gl=ke (Viewed 13th December, 2009). Lipsey; G. R and Chrystal; A.K (2007) Economics (11th Edition), Oxford University Press. Russell; M and Heathfield; D.F.(1999). Inflation and U.K. monetary policy, (3rd Edition) Heinemann. Read More