Introduction

In the United Kingdom, the central bank is the Bank of England (the “Bank”).

In this article, we briefly touch upon the Bank’s objectives, roles, powers, and governance, before discussing monetary policy in more depth.

Bank Mission

The Bank’s mission is to “promote the good of the people of the United Kingdom by maintaining monetary and financial stability”.

Monetary and financial stability are the two statutory objectives of the Bank under the Bank Act 1998.

Section 2A of the Bank Act 1998 states:

(1) An objective of the Bank shall be to protect and enhance the stability of the financial system of the United Kingdom (the “Financial Stability Objective”).

(2) In pursuing the Financial Stability Objective the Bank shall aim to work with other relevant bodies (including the Treasury and the Financial Conduct Authority).

Section 11 of the Bank Act 1998 states (our emphasis):

In relation to monetary policy, the objectives of the Bank shall be —

(a) to maintain price stability, and

(b) subject to that, to support the economic policy of His Majesty’s Government, including its objectives for growth and employment.

Price stability refers to inflation – the rate at which general price levels within an economy increase (see below).

The Bank is also the Prudential Regulation Authority (“PRA”), and has statutory objectives under the Financial Services and Market Act 2000 to promote the safety and soundness of those it regulates (section 2B) and secure an appropriate degree of protection for those who are or may become insurance policyholders (section 2C).

Roles and responsibilities

The Bank acts in various capacities and has a number of responsibilities, including (amongst others):

1. Acting as the UK’s prudential regulator for certain financial services firms – banks, building societies, insurers, and investment firms above a certain size. The functions of the PRA are exercised by the Bank’s Prudential Regulation Committee, which has overall responsibility for the PRA. Note – the Bank is the PRA, not separate from it;
2. Assessing and making decisions on financial stability through the Financial Policy Committee. As part of this, the Financial Policy Committee produces bi-annual Financial Stability Reports on the main risks to financial stability and the preparedness of the UK’s financial system to withstand these;
3. Acting as the UK’s Resolution Authority, with powers under the Banking Act 2009 in relation to the insolvency / restructuring of certain financial services firms;
4. Stress testing certain large financial services firms to ensure they can withstand shocks; and
5. Deciding upon and executing the UK’s monetary policy through the Monetary Policy Committee (see below).

Governance

Government oversight

From 1946, the Bank has been a public body.

From that time until 1997, the Bank acted as an agent of the UK government, doing as instructed. However, in 1997, the Blair government gave the Bank independence to exercise certain of its functions. This was to allow the Bank to make decisions to achieve its objectives without undue political interference.

Despite this, the Bank is still accountable to the government. In particular, the House of Commons Treasury Committee ask the Governor and other Bank senior representatives questions about monetary policy, financial stability, and prudential regulation. Further, the government appoints the members of the Bank’s Court of Directors (formally, the Crown makes the appointments, but the government runs the process).

Court of Directors

The Bank of England is governed by the Court of Directors (similar to a Board of Directors in a private company). The Court of Directors sets strategy and makes important decisions on spending and various appointments within the Bank.

The Court of Directors consists of:

1. The Governor – currently, Andrew Bailey;
2. Four Deputy Governors responsible for (1) Monetary Policy, (2) Financial Stability, (3) Markets, Banking and Resolution, and (4) Prudential Regulation;
3. Up to 9 non-executive directors, although there are usually (and presently) only 7 appointed.

The Bank’s Chief Operating Officer also attends meetings of the Court, but does not formally sit on it.

Policy Committees

Beneath this sit the three policy committees, including the Monetary Policy Committee (“MPC”), Financial Policy Committee (“FPC”), and Prudential Regulation Committee (“PRC”).

The Governor of the Bank sits on each of these Committees, in addition to the relevant Deputy Governor, and various external members (including some appointed by the Chancellor).

Other Court committees include the Audit and Risk Committee, Remuneration Committee, Nominations Committee, and Transactions Committee.

Further details on the various policy and Court committees and their members can be found here.

Inflation target

Pursuant to section 12 of the Bank Act 1998, His Majesty’s Treasury (“HMT”) can specify “what price stability is taken to consist of, or what the economic policy of His Majesty’s Government is taken to be”.

In this regard, the government has set an inflation target of 2% using the Consumer Price Index (“CPI”) measurement. The Bank must take steps to keep inflation at that target.

Surely price rises are bad, and the inflation target should be set at zero? Not necessarily.

As explained in our articles on aggregate supply (“AS”), low inflation is an indicator that there is plenty of spare capacity within an economy, and an economy can grow gross domestic product (“GDP”) through increasing aggregate demand (“AD”).

A moderate level of inflation suggests that spare capacity is being used, and GDP is growing.

However, too high inflation suggests that the economy is close to full capacity, and AD may be growing too quickly. Accordingly, governments and central banks may need to take steps to slow AD growth.

Monetary policy

The MPC meets at least 8 times a year (and at least once in any 10-week period) to decide upon and execute the Bank’s monetary policy to meet the 2% inflation target set by the Government.

Monetary policy relates to the setting of interest rates and controlling the supply of money.

If inflation is too high, this could indicate that an economy is operating at close to full capacity, and AD is too high in relation to AS. To bring AD down, the Bank can:

1. Increase interest rates; and
2. Decrease the supply of money.

If inflation is too low, this could indicate that an economy has plenty of spare capacity, and an economy can grow GDP through increasing AD. To increase AD, the Bank can:

1. Decrease interest rates; and
2. Increase the supply of money.

Interest rates and the supply of money are inextricably linked, and there is therefore some overlap when we discuss these below. It’s also a bit of a “chicken and egg” situation – do interest rates increase / decrease because money supply decreases / increases, or vice versa?

Interest rates

Price of money

A key concept to understand in this discussion is that interest is the price of money and is often expressed as an annual percentage of the money borrowed or deposited within an account.

If you borrow money, you will repay the amount borrowed plus interest at whatever rate it is set. By way of very simple example, if you borrow £100 to be repaid within a year, at a yearly interest rate of 1% which accrues at the end of the year, you will repay £101. Interest is the price you pay for the loan (although real-world products may also contain other fees).

Similarly, if you deposited money in a bank account with similar terms, the Bank would pay you £1 on top of your £100 deposit with them; interest is the price the bank pays you for being able to hold and use your money (yes, it doesn’t just sit there, it gets used! We discuss this further in our section on The City).

The supply of money and price of money have an inverse relationship. When the price of money (interest) is high, money is generally in less abundant in supply. When the price of money is low, money is generally more abundant in supply.

The Bank can control both the price (interest) and supply of money (within reason, of course).

Bank of England Base Rate

The Bank sets the UK’s base rate (the “Bank Rate”).

The Bank Rate is the interest rate that the Bank pays on deposits that commercial banks have with it.

Many retail and commercial financial products – mortgages, accounts, loans – are linked to the Bank Rate under their terms or correlate with it due to the Bank’s actions and market forces (explained below). This means that a change in the Bank Rate will have a real impact on the economy and individuals and firms within it.

If the Bank Rate increases, interest rates on new and existing products (that are not fixed) will rise and AD (and inflation) will decrease for the following reasons:

1. Debt products, such as mortgages and loans, will become more expensive. This will reduce the disposable income of firms and individuals with such products, meaning they have less money to spend and invest. Further, fewer firms and individuals may take out such products, meaning there is less spending and investment fuelled by debt. Together, these forces push down aggregate demand, noting that AD = C+I+G+(X-M);
2. Account and savings products will offer a better rate of return. This may encourage more people to save in an interest-bearing account, rather than spend. It may also reduce the amount of investment in companies. This is because returns on investments are not certain and are generally higher risk, higher reward. However, if interest rates are high, the rate of return on investments will need to be even higher to warrant taking on the additional risk. Together, these forces push down aggregate demand.

If the Bank Rate decreases, interest rates on new and existing products (that are not fixed) will fall and aggregate demand (and inflation) will increase for the following reasons:

1. Debt products, such as mortgages and loans, will become cheaper. This will increase the disposable income of firms and individuals with such products, meaning they have more money to spend and invest. Further, more firms and individuals may take out such products, meaning there is more spending and investment fuelled by debt. Together, these forces increase aggregate demand;
2. Account and savings products will offer a lower rate of return. This may encourage people to spend, rather than save. It may also increase the amount of investment in companies, since people may be attracted by the higher reward (despite the risk) versus low interest in an account. Together, these forces increase aggregate demand.

Influencing real interest rates

Background

Why do banks link their products to the Bank Rate or, if they don’t, why do the rates on those products broadly correlate in any event?

When the Bank sets the Bank Rate, it undertakes operations in the market to bring real interest rates to this level. Due to market forces and competition, banks are forced to pass the rate changes on to their customers or lose those customers and money.

It probably suffices to know that when the Bank Rate changes, real interest rates change (except in exceptional circumstances). We provide a simplified explanation below for those who are brave enough to continue…

First, you must understand that banks have their own cost of funding. In order to fund their lending, investments, or other activities (e.g. general operations), banks need to raise money. They can do this through obtaining retail funding, or wholesale funding (and using other cash on their balance sheet).

Retail funding includes obtaining deposits from customers (individuals and various non-financial or small companies).

Wholesale funding includes (amongst other things) issuance of bonds, borrowing money in the interbank market, or obtaining deposits from financial institutions or other large companies.

The interest or return that a bank pays on their funding sources, and other costs such as overheads, form a bank’s cost of funding – an average across all sources of funding is known as the average funding cost. Different institutions rely on a different split of funding sources, and have different average funding costs.

To make profits, banks must charge more interest on their lending products than their average funding cost. The difference between the average price of lending and average funding cost is known as the net interest margin and is one measure used to assess profitability.

The above is a very simplified explanation, assuming banks only make money from lending activities. However, further detail can be found at the following link.

Second, you must understand free market competition. Banks cannot set interest rates on their products in a vacuum. If they do not pay a competitive interest rate on deposits, customers may move their money elsewhere. Those banks will not have as much money to lend and may therefore suffer a loss in profits.

However, the higher interest a bank pays, the higher their cost of funding. Banks can absorb this cost, but this will decrease their profits. Alternatively, they can increase the interest rate charged on their lending products. However, if they increase it too much, or rates on lending products are much higher than market, this may cause borrowing to dry up and the bank will lose revenue. Banks therefore need to think carefully about how they react to Bank Rate and market interest rate changes, and are constantly looking at their competitors.

Market operations – Bank Rate and impact on real interest rates

The Bank, through its market operations, offers various accounts and borrowing facilities to eligible financial institutions. We do not set these out in full here, but further details can be found at the following link.

The Bank pays interest at the Bank Rate on accounts. Further, it charges the Bank Rate with a slight margin (for certain products) for lending to other banks. These activities impact on banks’ cost of funding, returns, and the interbank market.

By lending at or slightly over the Bank Rate, the Bank broadly sets the interest rate in the interbank market (which is one source of funding). A bank cannot charge much more interest than the Bank (if at all) in their interbank lending, otherwise other banks would rather borrow money from the Bank itself (although there will be a limit to this, hence the need for other sources of funding).

By paying interest at the Bank Rate, the Bank ensures that banks will not want to charge much less interest (if at all) than the Bank Rate on their interbank lending, otherwise their money could earn more sitting in an account with the Bank.

One other method the Bank uses to influence real interest rates is the buying or selling of assets within the market (bonds, gilts etc) – we discuss this below in the supply of money section.

The Bank’s lending and account activities have the impact of keeping interest rates in the interbank market broadly in line with the Bank Rate, which also impacts the interest on other funding sources (which keep up due to market forces).

For example, banks can also obtain money to fund their lending and other activities from depositors (current accounts, savings accounts, fixed term accounts, ISAs etc), and will pay interest on money deposited with them.

However, a bank cannot offer customers an interest rate on accounts that is too far apart from the cost of funding from other sources (such as in the interbank market). If the rate offered is too far below the cost of funding from other sources, other banks will be able to offer a higher interest rate on accounts (but still marginally below the cost from other sources) and steal customers. This will result in the first bank having less money to lend, lower revenues, and a weaker balance sheet.

Alternatively, if the interest rate offered on accounts is higher than the cost of funding from other sources, the bank will bring up its average cost of funding, which may lower profitability unless that cost is passed on (see below in relation to lending). That bank may also be better off getting money from elsewhere in this scenario.

Finally, a bank could also obtain money to fund their lending and other activities from issuing bonds etc. On seeing interest rates rise generally in the market, bondholders will want a higher rate of interest as compensation for their cash.

All the above have an impact on the average cost of funding, which will move with the Bank Rate except in exceptional circumstances. This in turn impacts the interest banks can charge on lending.

A bank cannot charge interest on their lending products that is significantly higher than the average cost of funding compared to other banks – otherwise those other banks will undercut them, and they will lose customers (demand will dry up). Further, they cannot charge less than their own cost of funding, otherwise they will lose money!

As you can see, the Bank doesn’t just declare the Bank Rate and be done with it. It takes action within the market to ensure that real interest rates change, which have an impact on banks’ costs of funding, which then impact interest paid or charged on real products to customers.

That said, there are occasions when banks’ costs of funding do not follow the Bank Rate despite the Bank’s actions, and more drastic measures need to be taken – an example of this is the 2007-08 financial crisis, when banks’ costs of funding rose significantly compared to the risk-free interest rates (which includes the Bank Rate).

Controlling money supply

Buying or selling assets

If the Bank wants to increase the supply of money within the economy, it can purchase various financial assets in the open market – such as UK government bonds (“gilts”) or corporate bonds. The government and companies, or the sellers of those assets on the secondary market, will then have more cash to spend in the economy, which will increase AD.

This will also decrease real interest rates within the market, since the price of assets goes up due to increased demand. By way of simplified example, if a bond costs £100 and pays £10 interest, it has a 10% interest yield. However, say the price of the bond increases on the open market to £150 due to increased demand, it will still only pay £10 and the interest yield will therefore be 6.66%.

Recall what we said above – interest is the price of money, and the more abundant something is, the lower its price.

If the Bank wants to decrease the supply of money within the economy, it can sell various financial assets and tie up investors’ (government and companies) cash. Those investors will have less cash to spend in the economy, which will decrease AD.

This will also increase real interest rates within the market, since the price of assets will decrease due to increased supply.

Quantitative easing

The Bank can acquire assets (as discussed above) using existing cash on its balance sheet.

However, if the Bank is trying to increase AD and inflation (and decrease interest rates) significantly, this may not be enough.

Accordingly, the Bank can create new electronic cash on its balance sheet, out of thin air, effectively printing electronic money.

It can then use this cash to acquire the assets listed above.

This process is known as quantitative easing and was used by the Bank and other central banks during and after the 2007 – 08 financial crisis to increase money supply (which was restricted due to the credit crunch), increase AD (and use up spare capacity), and increase inflation (which was at very low levels).

Printing notes

The Bank also prints bank notes for use in the economy. The Bank can determine how many notes are required based on demand, and can decrease or increase this accordingly.

Capital reserves

The Bank can also control the supply of money by changing the amount of capital reserves banks are required to hold. The higher this is, the less money banks can lend in the market, and less money will be in circulation.

However, in the UK (and many other countries) capital requirements are set by regulation. This is harder and slower to change, and is therefore likely to be a less effective tool than the others in controlling money supply. Instead, levels of capital reserves are often set to ensure banks maintain a prudent level of capital so they can withstand shocks to the economy.

Bank policy

Since the financial crisis in 2007 – 08 until around 2021, inflation was low, which suggested there was plenty of spare capacity within the economy (which, as explained, many economists think is more likely after a demand-deficient recession).

Accordingly, the Bank kept the Bank Rate at historically low levels (and market interest rates followed) – 0.1% until 17 December 2021, when the Bank started to slowly increase the Bank Rate. The Bank also engaged in quantitative easing. Other central banks around the world did likewise.

The aim of this was to increase AD and inflation, and fuel economic growth by using up the spare capacity within the economy.

However, as we came out of the Covid-19 pandemic, AD increased rapidly and spare capacity within the economy was used up. This was coupled with a decrease in AS due to world events, such as the war in Ukraine – which resulted in a reduction in supply of fossil fuels, thereby increasing their price (recall, AS decreases when the quantity or quality of the factors of production decrease / their costs increase).

Due to this, the UK and the world saw a rapid rise in inflation. The Bank and other central banks have therefore been increasing interest rates in an attempt to bring AD down and bring inflation back under control.

Conclusion

You should now have a good understanding of the Bank of England and what monetary policy tools it can use to control AD and inflation. In summary:

• The Bank is the UK’s central bank and acts in various capacities, and has a range of roles and responsibilities;
• The Bank sets and executes the UK’s monetary policy. Monetary policy relates to interest rates and the supply of money; these inextricably linked;
• The Government has set a 2% CPI inflation target, which the Bank has to try to meet through monetary policy;
• To decrease AD and inflation, the Bank can take steps to increase interest rates and decrease the supply of money; individuals and firms will have less money to spend in the economy;
• To increase AD and inflation, the Bank can take steps to decrease interest rates and increase the supply of money; individuals and firms will have more money to spend in the economy;
• The Bank sets the Bank Rate – which is the amount of interest the Bank pays on deposits that banks hold with it. The Bank also undertakes lending in the interbank market by reference to the Bank Rate (often with a slight margin). This impacts real interest rates and banks’ costs of funding, which impacts interest rates on products offered by banks to customers;
• The Bank can influence the supply of money within the economy by (i) buying or selling financial assets with cash on balance sheet, or by creating more money to do so (known as quantitative easing); (ii) printing more notes; (iii) changing bank reserve requirements.