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Foundations of Finance and Investment - Essay Example

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Foundations of Finance and Investment

The Repo rate is the short-term interest rate at which financial institutions such as banks and building societies can borrow money from the BOE for a two-week period. The MPC meets monthly to set the Repo rate as part of its monetary policy function to control inflation. Its decision on what this rate should be acts as a signal to the money markets of how much to pay savers and charge borrowers for the use of money. The Repo rate therefore acts as the baseline for the cost of money that can be loaned to customers, which can include other banks, in the form of mortgages and overdrafts (BOE, 2005).
Many households and firms, however, borrow for longer time periods and prefer to fix borrowing costs in advance, either because this helps them plan their cash flows better or protects them from the future risk of rising interest rates. This is a gamble some lenders and borrowers take, since interest rates may also move the other way. Fixed long-term borrowing or interest rates are relevant to those who want fixed-rate mortgages for housing or to firms with long-term investment plans like expanding a factory that needs some years to pay off. Long-term interest rates ranging from one to ten years are calculated simply by taking an average of forecast short-term interest rates over the desired period.
Short- and long-term interest rates are closely related, but differ on the basis of MPC decisions; the expectations of how the national economy will fare; the expected future inflation rates; and how likely the MPC will achieve its inflation targets (BOE, 2005).
The direction of short-term rates is easy to determine because the figure depends on the latest interest rate decision of the MPC that can either raise or lower the Repo rate. Long-term rates, however, may go either way, determined by how the economy will perform many years from now. It can happen that whilst the MPC raises the Repo rate next month, ten-year rates may go down if the market thinks such a decision will cause rates to fall in the future. Future rates depend on how reliable the market finds the MPC (Barrell et al., 2006, p. 60).
In deciding to keep the Repo rate at the same level in April 2006, the MPC considered several rigorously monitored variables such as U.K. inflation (down from 2.0% to 1.8%), money supply (M4, the sum of notes, coins, and so-called broad money consisting of what is held in bank and building society accounts, grew 12% in the year to February), economic growth (in line with first quarter trend rate at 0.6%), U.K. consumer spending and manufacturing (growing steadily), asset prices (rising prices of equities and houses), the sterling exchange rate (weakening or depreciating to the dollar and the Euro), risk of higher inflation (rising due to the increase in energy and oil prices), the economic performance of the U.S., the so-called Eurozone (EU countries that have the Euro as its common currency), and Japan (inflation, exchange rates, asset prices, etc.), wage pressures (rising average real product wage balanced by lower growth of average real consumption wage; the first refers to the real cost incurred by employers whilst the second refers to the take home pay of employees), and consumer surveys on inflationary expectations (rising), a key emotional factor that influences personal decisions to either save or spend.
Inflation - the rise in prices of a basket of goods and services in the whole economy - if ...Show more

Summary

The Monetary Policy Committee (MPC) of the Bank of England (BOE) decided in April to keep the Repo rate at 4.50% (BOE, 2006). Forecasts by over forty City and non-City financial institutions showed a rate lower by 25 basis points at year-end, with a median forecast of 4.25% (HMT, 2006)…
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