The Bank of England and Interest Rate Policy - Case Study Example

The Bank of England and Interest Rate Policy THE BANK OF ENGLAND AND INTEREST RATE POLICY Introduction The UK public expects the country’s monetary policy to change as the governor of the Bank of England has communicated that other indicators, rather than just unemployment, will be used to determine the bank’s rate policy (Mark Carney adjusts Bank interest rate policy, 2014: p1). The falling unemployment levels in the country have necessitated this. In addition, the forward guidance adopted by the bank has been successful in securing growth. These facts have made the UK public certain that probably there could be an upsurge in interest rates for the next year. Since the forward guidance linked to the interest rates was closely related to unemployment rates, the current rate of the latter, which is almost at the bank’s recommended threshold, has obliged the Bank of England to restructure its forward guidance. This is set to be evidenced in the consideration of more economic variables in setting of interest rates, which will be based on expectations in the market of interest rates of 2%, up from the current 0.5%, in the next three years (Mark Carney adjusts Bank interest rate policy, 2014: p1). However, the bank has also said that the bank rate will not go over 5% even after the economy recovers. Effect of Increasing Interest Rates This increase in the Bank of England’s base rate will initially result in higher commercial rates also. The increase will have a diverse effect on macro-economic indicators. First, the cost of borrowing will increase as interest payments on loans, as well as credit cards, become increasingly expensive (How the Bank of Englands policy affects you, 2013: p1). Because this will discourage borrowing, whereas those with loans will have less income to dispose of, consumption will fall in other areas. Interest payments for mortgages are also due to increase, which will heavily affect consumer spending as it will significantly impact on individual disposable income. Individuals will also be more inclined to save, instead of spending, especially since higher interest rates will also result in higher gained interest, which is conducive for deposit accounts. The value of the £ will also increase as investors prefer to save in UK banks, increasing imports and decreasing exports, making exports less competitive and reducing the economy’s aggregate demand (Cagan, 2012: p45). An increase in interest rates as expected from the Bank of England on savings deposits and loans across the economy may portend a significant effect on income distribution in the UK (Chadha & Holly, 2012: p44). The official policy since March of 2009 for interest rates in the UK has been at 0.5%, which is a historic low. This lengthy time period that has allowed for low returns to savers has dramatically increased the redistribution of income to borrowers and away from savers, especially for borrowers on mortgages with variable rates. It has been estimated that UK savers lost over £40 billion since 2009 due to low interest rates. However, there have been dramatic gains for mortgage borrowers with less interest paid on their loans. Increasing the interest rate will lead to higher incomes for savers, coupled to lower income for borrowers (Driffill, 2011: p51). Individuals with positive net savings will gain from the increase in rates, which will benefit pensioners and others who are reliant on life savings as their main source of income. Changes in interest rates also have a significant effect on spending. If it happens that the Bank of England increases interest rates, the result will be that consumers have less disposable income, meaning they will cut back on spending. If the increase in interest rates is tied to increased standards of lending by the banks, they will give fewer loans. Not only with this have an effect on the consumer, it will also impact farmers and firms as they will be forced to cut back spending on new machinery and equipment (Walters, 2013: p59). This will add up to a decline in the number of employees, increasing unemployment levels, and slow down productivity. More stringent standards of lending will also mean that consumers will reduce spending; affecting the bottom lines of many UK businesses. Finally, the decreased ability for consumers to spend will have a ripple effect on the entire economy with regards to spending (Slovin & Sushka, 2012: p61). Thus, an increase in interest rates will reduce spending, as well as investment, leading to a drop in AD as shown below. (Slovin & Sushka, 2012: p68) Figure 1 Impact of Increasing Interest Rates on AD Changes in the interest rates will also impact on inflation in the UK. The funds rate, which is the rate at which banks lend money to one another, changes regularly and, due to the fact that it has effects on other loan rates, it is a reliable indicator on whether interest rates are declining or rising (Martin & Milas, 2009: p214). These changes affect inflation, which is the increase in price of services and goods over a period of time. Although it is the result of a healthy and strong economy, it also leads to significant purchasing power loss if it is not checked. The Bank of England helps to manage inflation levels by watching indicators on inflation like the Producer Price Index and the Consumer price Index. If these indicators rise over 2-3% in one year, the Bank of England increases the funds rate to manage better rising prices (Fuhrer & Madigan, 2009: p577). Since increased interest rates result in increased costs of borrowing, consumers eventually begin to spend less. This amounts to a drop in demand for service and goods, causing a fall in the levels of inflation. Finally, interest rates also affect the UK bond and stock markets. Since investors have a diverse array of options to invest, they will normally choose the investment option that gives them a high return rate (Norton, 2013: p22). The current Bank of England fund rates determine the manner in which investors invest their funds. Changes in interest rates also affect the psychology of businesses and consumers. The increase in interest rates means cut back on spending by both, causing decline earnings, as well as in the prices of stock. In addition, the relation between interest rates and bond rates is such that an increase in the former results in a fall, in bond prices. Bonds that take longer to mature are the most sensitive to these fluctuations in interest rates. Businesses and governments rely on the sale of bonds to raise money and, as interest rates are increased, it is expected that it will become more expensive to borrow. This will have the effect of decreasing the demand for bonds with lower yields, causing their prices to drop (Floyd, 2010: p54). The Role of Forward Guidance The Bank of England uses forward guidance and other Central Banks in exercise of its monetary policy powers, seeking to influence market expectations regarding future interest rate levels using their own forecasts (Q&A: What is forward guidance?, 2014: p1). In this incident, the Bank of England will promise to ensure lower interest rates for a longer time compared to that signalled by its reaction function. The forward guidance provided by the Bank of England gives clarity regarding intentions of monetary policy and interest rates, resulting in better outcomes by reducing financial and economic uncertainty. Individuals in the UK make decisions on the basis of future interest rates expectations with saving and spending decisions dependent on rates offered on deposits and charged on loans. The Monetary Policy Committee communicates on its intentions to maintain stability of prices, whereas also supporting the employment and growth aims of the government (Strum, 2009: p623). These regular communications are sharpened through giving explicit forward guidance. The recent financial and economic uncertainty has made it more difficult for people to form independent expectations regarding inflation outlook and future monetary policy direction, especially if it is solely based on past experience (Cobham, 2013: p 31). Because the growth in productivity and output have been weak since 2009 with inflation levels soaring above target, forward guidance helps the Bank of England to communicate more clearly how it will react if inflation deviates from the target. Thus, individuals can understand how the Bank of England will trade off their decision to get inflation back to initial targets against the context of economic growth (Kaseeram, 2010: p100). Additionally, forward guidance informs individuals about how the Bank of England will respond to unexpected developments. Forward guidance also reduces uncertainty regarding the future path of interest rates and general monetary policy for firms, households, and financial market participants, which aids in enhancing the effectiveness of monetary policy stimulus (economist.com, 2014: p1). Providing forward guidance is especially useful as recovery gains traction, particularly given the risk of financial markets overreacting to recovery signals and having very high expectations of future interest rates, which could stifle recovery by tightening monetary conditions. In addition, it also reduces risks of the financial markets reacting to overseas news inappropriately, for example, in the current expectations of monetary policy direction in the United States. Forward guidance should also aid people in comprehending why interest rates will be set in a particular way so as to reduce chances of misinterpretation (Jansson & Vredin, 2008: p355). If people misunderstand the intentions of the Bank of England, they may react in a way that diverts the earlier intentions of the policy change. Presently, the Bank of England views forward guidance as necessary, especially with regards to the future direction of interest rates and its asset purchase program (Norton & Vähämaa, 2014: p351). This signals that they intend to maintain the simulative approach to monetary policy until there is a significant narrowing of the economic margin of slack, as long as this is consistent with their intention to maintain price stability sans causing financial instabilities. Further purchase of assets is then viewed as a policy tool to be used at discretion, especially if it is important to increase monetary stimulus. In order to uphold the existing monetary policy stance, the Bank of England does not intend to reduce the use of central bank reserves in financing asset purchases (Norton & Vähämaa, 2014: p351), intending to use the Asset Purchase Facility’s maturing gilts cash flows for reinvesting. Finally, forward guidance allows the Bank of England to explore scope for economic expansion sans jeopardizing financial and price stability (Bhattarai, 2013: p23). As aforementioned, trade off between how inflation is altered to initial targets and the time taken by employment and output to improve is not currently certain. In addition, the fact that interest rates have been on a low in the last five years means that more trade off exists between monetary policy support and the risk it would portend on financial stability. The Bank of England is offering forward guidance to avoid any misjudgement of both trade offs and the medium term costs of this misjudgement. Shock to the UK economy recently and the resultant high inflation and demand depression has caused exceptional productivity weaknesses. Although this weakness could unwind because it is linked to demand, which should improve as the economy improves; it may also affect other factors that will only improve gradually with economic recovery, such as reallocation of resources across the economy (Bhattarai, 2013: p25). Conclusion After giving forward guidance that there would be no increase in interest rates until unemployment levels fell below the targeted 7%, the Bank of England, has based on declining levels of unemployment, disclosed that it will now use other factors to determine interest rates. Since the decisions to increase interest rates from their historical low of 0.5% will no longer rely on unemployment levels only, there is expectation that this will rise. This should result in an increase in borrowing costs, increased income for borrowers and declining income for savers, decreased inflation, and less spending. Thus, the Bank of England has offered this forward guidance in order to provide improved clarity about the bank’s view of how appropriate trade-offs between how targeted inflation is achieved and the speed at which employment and growth will recover. It will also reduce any uncertainty arising from future interest rate changes with the economy’s recovery. Finally, giving forward guidance on changes on possible future interest rate changes also increases the scope within which the Bank of England can expand the economy without risking financial and price stability. This will reduce the fall out following any increase in interest rates and the resulting effects as discussed. References Bhattarai, K. (2013). An analysis of interest rate determination in the UK and four major leadingeconomies. Kingston upon Hull, Hull University Business School. Cagan, P. (2012). The channels of monetary effects on interest rates. New York, National Bureau of Economic Research; distributed by Columbia University Press. Chadha, J., & Holly, S. (2012). Interest rates, prices and liquidity: lessons from the financial crisis. Cambridge, Cambridge University Press. Cobham, D. (2013). The Making of Monetary Policy in the UK. Chichester, John Wiley & Sons economist.com. (2014, February 15). Forward progress. Retrieved March 20, 2014, from The Economist: http://www.economist.com/news/britain/21596534-mark-carney-has-second-crack-forward-guidance-forward-progress Driffill, J. (2011). 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