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% annually—the 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.
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.
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 difficult—so 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 quickly—like the effect on people’s expectations—the 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.
Isn't it nice to have the whole picture?
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