Bank of England: The Significance of the Base Rate Rising… Again

As of the 3rd August 2023, the Bank of England base rate increased to 5.25%. This is the fourteenth time in a row that they have raised interest rates and the highest it has been for 15 years. In this article, we will look at the history of the Bank of England and the significance that interest rates play on the national and global economy.

The Bank of England base rate, often referred to as the “interest rate” or “base rate,” is a key monetary policy tool used by the Bank of England to influence economic conditions in the United Kingdom. It is the interest rate at which the Bank of England lends money to other banks and financial institutions in the country, and it serves as a benchmark for other interest rates in the UK economy.

A Brief History of the Bank of England

The Bank of England, established in 1694, holds the distinction of being the world’s second-oldest central bank (the first being the Sveriges Riksbank in Sweden, founded in 1668). Its formation was a response to the financial challenges faced by the English government during the late 17th century, particularly in funding wars and managing public debt.

The bank was initially a private institution formed by a group of wealthy merchants and financiers. The main purpose of its creation was to raise capital for King William III’s war efforts against France. In return for their investment, subscribers received interest on government debt and were granted the right to issue notes that could be used as currency.

Over time, the Bank of England evolved into a national institution with significant influence over the country’s financial system. In 1844, the Bank Charter Act was passed, which gave the Bank of England a monopoly on issuing banknotes in England and Wales. This act also established the concept of “fiduciary issue,” where the bank’s issuance of notes was backed by a specified amount of gold reserves.

Throughout the 20th century, the Bank of England’s role expanded further, with a focus on monetary policy, financial stability, and banking supervision. In 1997, the bank’s operational independence was granted, meaning that it became responsible for setting interest rates and making monetary policy decisions without direct interference from the government.

The history of the base rate dates back to the early 18th century when the Bank of England began charging interest on loans provided to banks. Throughout the years, the base rate has undergone numerous fluctuations in response to changing economic conditions and inflationary pressures.

Before the 1970s, the Bank of England had a more informal approach to setting interest rates. However, in the 1970s and 1980s, inflation surged in the UK, prompting the central bank to adopt a more formal and transparent approach to monetary policy. Since then, the base rate has been set by the Bank of England’s Monetary Policy Committee (MPC) through regular meetings, where the committee assesses economic data and conditions before making rate decisions.

Over time, the base rate has been used to navigate various economic challenges, including inflationary spikes, economic recessions, and financial crises. It has been adjusted up and down to stimulate or cool down economic activity and to achieve the Bank of England’s target for inflation, which has been set at 2% since 2003.

How the Bank of England impacts us today

The significance of the Bank of England base rate lies in its impact on various aspects of the economy:

Controlling Inflation

One of the primary objectives of the Bank of England is to maintain price stability and control inflation. By adjusting the base rate, the central bank can influence borrowing costs and, consequently, consumer spending and business investment. Higher interest rates tend to reduce borrowing and spending, which can help to cool down an overheating economy and curb inflationary pressures. Conversely, lower interest rates can encourage borrowing and spending to stimulate economic growth when there is a risk of deflation or economic slowdown.

In the past 12 months, inflation (as measured by the retail price index – RPI – has been as high as 14.2%. The latest figures for June 2023 from the Office for National Statistics, inflation stands at 10.7%. This has therefore been the primary motivation for increasing the base rate, but there are other reasons.

Source: https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/czbh/mm23

Monetary Policy Transmission

Changes in the base rate act as a signal to financial institutions and the wider economy. When the Bank of England raises or lowers the base rate, commercial banks typically adjust their own lending rates, such as mortgage rates, personal loan rates, and business loan rates, in response. This mechanism is known as the “monetary policy transmission mechanism,” and it affects the cost of borrowing for households and businesses, influencing their spending and investment decisions.

This has been the biggest news story in the UK and arguably has had the largest impact on the average Brit. As banks raise their mortgage interest rates, borrowers’ interest repayments increase. With interest rates during the previous 10-15 years being historically low, the sudden sharp rise in rates has come as a shock to most people who have a mortgage.

Exchange Rate Effects

Interest rates can also influence the exchange rate of a country’s currency. When the Bank of England raises interest rates, it can attract foreign capital seeking higher returns, leading to an appreciation of the British pound. On the other hand, lowering interest rates can make UK assets less attractive to foreign investors, leading to a depreciation of the pound. Exchange rate movements, in turn, can impact exports and imports, affecting the balance of trade and overall economic activity.

This is a key consideration for international businesses. For example, a company could translate some Euros into pounds sterling, hold their funds in an interest-bearing account, which would earn a higher rate of interest than the Eurozone, and finally translate their funds + interest back into euros. This type of activity multiple times over has a bearing on the exchange rates in international money markets.

Financial Markets

Changes in the base rate can have significant effects on financial markets. For example, higher interest rates may lead to lower stock prices as investors seek higher returns from fixed-income assets. Additionally, bond prices tend to fall when interest rates rise, as newly issued bonds with higher yields become more attractive.

Consumer Spending and Saving

The base rate can influence consumer behaviour, affecting their willingness to spend or save. Higher interest rates may encourage saving due to higher returns on savings accounts and other interest-bearing assets, while lower interest rates can incentivize spending and discourage saving.

The base rate can influence consumer behaviour, affecting their willingness to spend or save. Higher interest rates may encourage saving due to higher returns on savings accounts and other interest-bearing assets, while lower interest rates can incentivize spending and discourage saving.

Debt Levels and Repayment

Changes in the base rate can impact debt levels and debt repayment capacity for individuals and businesses. Higher interest rates can increase the cost of servicing debt, potentially leading to reduced borrowing and higher default rates, particularly for those with variable-rate loans.

Overall, the Bank of England base rate plays a crucial role in steering the UK economy towards its monetary policy objectives and maintaining stability in financial markets. As such, the decisions made by the Bank’s Monetary Policy Committee regarding changes to the base rate are closely watched by policymakers, businesses, investors, and the public.

Significance in the UK Economy

As seen from above. the Bank of England base rate holds immense importance in the UK economy as it serves as a lever to achieve the bank’s primary objective of maintaining price stability and controlling inflation. By raising or lowering the base rate, the Bank of England can influence borrowing costs for banks and other financial institutions, which, in turn, impact consumer spending and business investments. Higher interest rates act as a deterrent to borrowing and spending, thereby curbing inflationary pressures during economic expansions. Conversely, lowering interest rates can stimulate economic growth and encourage borrowing when there is a risk of deflation or economic slowdown.

Furthermore, the base rate plays a pivotal role in shaping the exchange rate of the British pound, impacting trade and investment flows with other countries. Fluctuations in the pound’s value can affect the competitiveness of UK exports and influence the cost of imports, influencing the nation’s balance of trade and its overall economic performance.

Global Implications

The Bank of England’s base rate decisions reverberate well beyond the UK’s shores, carrying significant implications for the global economy. As one of the world’s major financial centres, London plays a critical role in international finance and foreign exchange markets. Changes in the base rate can influence global investors’ risk appetite and capital flows, affecting financial markets worldwide.

Additionally, the Bank of England’s monetary policy decisions can impact other central banks’ policies, leading to coordinated or divergent actions among major economies. Changes in interest rates by a major central bank like the Bank of England can influence the decisions of other central banks in their pursuit of domestic economic objectives, leading to interconnected monetary policies.

Conclusion

In conclusion, the Bank of England base rate’s historical significance as a key monetary policy tool, its role in guiding the UK economy, and its impact on the global financial landscape underscore its importance in the realm of international finance. As economic conditions continue to evolve, the Bank of England’s base rate remains an essential instrument in steering economic stability and growth, both domestically and internationally.