Economy introductions: the idea behind interest rate changes

Published: 5th Aug 2016

By changing short term interest rates, the Bank of England can alter the cost of borrowing money in the rest of the economy. Its aim is to “influence the overall level of activity in the economy”, and ultimately inflation.

In August 2016, the Bank of England set the official bank rate at 0.25% annuallythe lowest it’s ever been.

Lower interest rates should mean faster growth

When the Bank of England’s interest rate is low, it’s cheaper for banks to fund themselves.

In theory, this means they’ll be able lend to businesses and households at lower rates too, so a low ‘bank rate’ should mean lower interest rates for everyone else. Interest rates on new loans will be likely to fall, as will variable-rate mortgages.

This gives businesses and households more incentives to borrow and fewer incentives to save, encouraging spending and economic growth.

Lower interest rates in the UK might give some investors an incentive to save money in countries that have higher interest rates, using other currencies. This puts downward pressure on the value of the pound soon after the cut is announced, although the precise long-term effect may be uncertain.

Other investors switch to holding on to government bonds or shares in companies, pushing up their price.

Lower interest rates should mean faster price changes

According to the theory, when interest rates are lower more money will be spent. When more money is being spent, prices for consumer goods will rise faster.

If prices rise too fast then inflation will rise above the Bank of England’s inflation target, set by the Treasury. The current target is for prices to rise by 2% per year.

Usually at that point, the Bank of England would raise interest rates again, making it more expensive for other banks to borrow and lend money and, as a consequence, pushing up interest rates for businesses and households.

Saving would become more attractive because interest rates on savings accounts would become higher, while borrowing and spending would become more difficultso the economy would slow down.

Sometimes the Bank prioritises keeping a suitable level of employment and economic output over hitting its inflation target exactly, as it did in August 2016.

Interest rate changes take time to affect the economy

Changes in this interest rate should, in theory, influence other interest rates, the growth rate of the economy, and the rate of price inflation. But monetary policy takes time. Although some of its effects take hold very quicklylike the effect on people’s expectationsthe full effect on inflation takes up to two years to work through.

Interest rates have been low since 2009

The Bank of England hasn’t raised its official rate since July 2007, when the rate went to 5.75%. By March 2009 the bank rate had been cut to 0.5%, and it stayed that way until August 2016, when it was cut to 0.25%, a historic low.

The Bank has also used new ‘unconventional monetary policies’ like quantitative easing to try and encourage economic growth and push inflation towards its target level.

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