No Change in Bank of England Interest Rates: More of the Same???

Home » Blog » 2016 » February » 04 » No Change in Bank…

For the first time since August 2015, members of the Bank of England’s MPC unanimously voted to maintain the Bank base rate at 0.5%. But why?

The Bank of England Mandate and Central Bank Interest Rates

According to the Bank of England (BoE), their primary mandate is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives for growth and employment. Price stability is defined by the government’s inflation target of 2%.

Conventional monetary policy entails the BoE attempting to influence aggregate demand in order to keep prices stable. The idea is to ensure that aggregate demand is: 1) not too high, as this would increase consumer prices by more than 2%, and 2) not too low, as this would prompt prices to decline (which could lead to deflation).

The BoE attempts to influence aggregate demand by altering the ‘base’ rate of interest on the reserves that banks hold at the BoE. In turn, this is intended to change interest rates that banks charge their borrowers, changing the level of debt and money created by the private banking sector.

Lowering base rates is thus intended to stimulate private sector borrowing, more bank money creation, increasing the available purchasing power, and thus boosting aggregate demand. But lowering base rates will also increase demand by lowering the debt servicing costs of people with loans. The lower cost of servicing debt means that the private sector will have ‘extra’ disposable income to spend on goods and services.

In contrast, increasing interest rates will have the opposite effect. Higher interest rates should reduce demand for new money-creating loans, diminishing the available purchasing power in the economy as existing loans are paid down, eventually contracting aggregate demand. An increase in interest rates will also depress aggregate demand, by increasing the debt-servicing costs for existing loans. The higher cost of servicing debt would mean that current debtors in the private sector will have less disposable income (than otherwise would be the case) to spend on goods and services.

High Asset Prices and Low Interest Rates

The problem with low interest rates is that they tend to lead to higher asset prices in the financial markets and can even cause asset price bubbles. This is primarily because 80% of new bank lending tends to be for pre-existing assets in the financial and property markets. So by trying to stimulate bank lending, the BoE inevitably encourages higher asset prices and potential bubbles.

It’s hardly surprising therefore that four ex-central bankers, including the likes of Jean-Claude Trichet (former president of the ECB) and Axel Webber (former president of the Deutsche Bundesbank), recently wrote a paper warning central banks about low interest rates:

“The long period of extremely easy monetary conditions [low interest rates] has not generated inflationary pressures in the advanced market economies. However, it might well have contributed to further misallocations of real resources in the economy, to reducing potential output, and to unsustainable increases in asset prices.”

Indeed, as Adair Turner pointed out in 2013 trying to stimulate aggregate demand by getting banks to lend more is extremely dangerous given that excessive private debt is what caused the global financial crisis to begin with:

“We got into this mess because of excessive creation of private credit and money: we should be concerned if our only escape route implies building up a future excess.”

Current Economic Conditions

At present inflation is far below the BoE’s mandated target of 2%. The BoE further explains why it is not hitting its target:

“In December, twelve-month CPI inflation stood at 0.2%, almost 2 percentage points below the inflation target. Oil prices were more than a third lower, in sterling terms, than a year earlier. Together with muted growth in world prices, the appreciation of sterling since early 2013 has pulled down on import prices more broadly. Overall, these factors can explain the vast majority of the deviation of inflation from the target in December, and to an even greater extent than at the time of the November Inflation Report. The remainder of the undershoot reflects subdued domestic cost growth, particularly unit labour costs.”

These conditions suggest that raising interest rates would be unwise. But also, having recently spoken to a former MPC member it was suggested to me that households are financially stretched, and the BoE is worried about what households will do when interest rates rise. With such a high level of private debt in the UK, an increase in interest rates will increase the debt servicing costs of people who have taken out a loan. This would reduce the disposable income of the private sector, reducing spending and aggregate demand.

The Dilemma

So the BoE currently faces an extremely tough task when deciding whether to change interest rates. Keeping interest rates low will increase asset prices and accentuate any potential bubbles, which risks creating financial instability and another crisis. But keeping interest rates low is necessary to keep aggregate demand at its current level, so that prices do not fall even further.

On the other hand, a rise in rates could curb the rise in asset prices and prevent potential bubbles from emerging. But any rate rise could depress aggregate demand and prompt a decline in prices.

This catch-22 situation demonstrates the current limitations and ineffectiveness of the policy ‘toolkit’ available to central banks. It also illustrates the dearth of ideas within mainstream policy-making circles. To address this deficit in ideas Positive Money advocates the establishment of a money commission.

Stay in touch

Tags: , , ,

Trackback from your site.

Frank Van Lerven

Frank is our Research and Policy Analyst, and is responsible for our research on current events. Frank also leads our research in Public Money Creation and Quantitative Easing. Prior to working on the availability of credit under a Sovereign Money system, Frank also researched issues related to the 1844 Bank Charter Act and its implications for contemporary monetary policy. With a Research Master’s in Advanced Political Economy (cum laude) and a BA in African Development Studies, Frank is especially interested in how Western financial systems (and models) influence developing economies.
  • Vince Richardson

    Catch 22 sums this up perfectly.We spend much time,or at least economists,polticians and the media do ,arguing about how to put things right.In the current system we have that is impossible.Such a waste of talent and effort.Sometimes you just have to think outside the box.

  • James Murray

    Yet again, very well explained Frank.
    It is a pity that such a classic, timeless account is only found in a blog and not on a more accessible webpage on the site.
    I realise that there are four tags, but wonder if those searching for such a clear explanation of the functions and effects of the BoE’s MPC would reach this blog page, and then of course be introduced to PM.
    But I do like the ‘hook’ at the end.

No Announcement posts

back to top