Inflation is a measure of changes in prices over a specified period and the objective of the monetary policy is to set the interest rate so that inflation can be brought back to target within a reasonable duration.
Bank rate is therefore an essential tool used by the Bank of England to control the inflation rate. When Bank believes inflation is beginning to rise, it raises interest rates to cool the economy and vice versa.
However this formula has many exceptions as proved by the recent rate cuts by the Bank of England. Although factory gate inflation (based on prices of good leaving factory) reached a 16 year high in December 2007 influenced by rising oil and food prices and CPI stood at 2.1 %, the Bank still went ahead with rate cut. It is interesting to understand why.
Although bank rate is used as a tool to control inflation, it is first important to understand that there are different ways of measuring inflation. The Consumer Prices Index (CPI) and Retail Prices Index (RPI) are used in UK to measure inflation and usually have separate values. This is because of the difference in goods and services they cover and the method of calculation.
The Government inflation target, which is currently 2%, is based on CPI. ...
aper the most important difference that needs to be considered is that CPI does not include certain housing costs, such as mortgage interest payments.
The reasons for the rate cut was not a isolated decision by the Bank of England but was influenced by the crisis in the global financial market as a result of what has now come to be known as subprime mortgage crisis. Subprime is the general term used to refer to lending to borrowers who do not normally qualify for standard market rates for various reasons such bad credit history or lack of stable income. Obviously these borrowers are a greater risk to the financial institutions.
For many years, Cleveland in America was the major market for the sub-prime lenders where the brokers informed the residents that they could obtain cash by refinancing their homes, "but often neglected to properly explain that the new sub-prime mortgages would reset after 2 years at double the interest rate" (BBC, 2007). As the home owners were subsequently unable to afford repayments, this resulted in a wave of repossessions. As the sub-prime lending had spread across America, the same story has been repeated.
As many borrowers defaulted on payments, the financial institutions felt the credit crunch which reflected on other developed economies such as UK. The lenders in UK tightened their loan conditions in response to the US financial slump, especially in the sub prime market which has influenced the price of property in UK. The profitability of the financial services sector, which has been a key driver of UK economic growth in recent years, has also been affected.
As the housing demand in UK showed a decline, this resulted in a general fear of economic slowdown. At this stage, the Bank of England faced a dilemma between a rise