Bank of England Reduces Bank Rate by 0.25 Percentage Points to 5.25% - Essay Example

Bank of England reduces bank rate by 0.25 percentage points to 5.25 Introduction The Bank of England, sometimes known as the 'Old Lady' of Threadneedle Street, performs all the function of a central bank including maintaining of monetary stability. Maintaining stable prices are an important requirement of the monetary stability and it is the responsibility of the Bank to decide on the level of short-term interest rates necessary to meet the Government's inflation target which is currently at 2%. It should be noted that a target of 2% does not necessarily mean keeping the inflation at this constant rate. "That would neither be possible nor desirable" (www.bankofengland.co.uk). Interest rates are dependent on prices of goods and services which are changing all the time. 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. 2. Reasons for the decrease: 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. It is more comparable measure of inflation internationally and is believed to give better picture in terms of consumer behavior and spending pattern. Although CPI differs in many ways from RPI, for the current paper 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 in inflation in the short-term and a sharp slowdown in economic growth. The Bank decided to go for the rate cut to 5.5% in December 2007 in a unanimous decision which was followed by a second rate cut in February to 5.25%. 3. Consequences on financial market and UK economy: Any change in the bank rate of the Bank of England has an overall impact in the financial market and the economy. Although the bank rate is used as a tool to control the inflation, this happens indirectly with other factors being influenced as seen in figure 1. Fig 1: From interest rate to inflation (Source: www.bankofengland.co.uk) As the bank rate is the rate at which Bank of England lends to other financial institutions, lowering of rate has a direct influence on the lending rate of commercial banks, building societies and other financial institutions. The bank rate affects the interest rates charged for mortgages and saving accounts. As interest rates decrease, spending becomes more attractive which in turn stimulates the economy. As consumers spend more money this causes increase in demand and subsequently inflation. This combined with the rapid rise in prices of energy and oil is expected to push the actual CPI above 3% from 2.2 % in January even though the current Government inflation target is 2%. It is worth pointing out that if UK inflation exceeds the target by more than 1 percentage point, the Governor must write an open letter to the Chancellor explaining the reasons why inflation increased and what the bank plans to do about it. At the same time the property prices have continued to decline. As mentioned previously, CPI excludes mortgages. The Bank of England is therefore, in a critical position to balance inflation with falling property prices. The question at the moment is if the rate cut is sufficient to stop the drop in property prices. Although it is too early to see the actual affect of the rate cut in the property market in UK, general view seems to be that the property price will continue to decline as the slowdown in economy becomes clearer. Further rate cut is generally propagated by many experts to stop the decline in property prices. Decreasing the bank rate does increase confidence in the market in turmoil situations. After the subprime crisis, many financial institutions faced credit crunch which was aggravated by a sharp spike in interest rates in money markets. A prominent example is that of Northern Rock which collapsed in September as the bank relied on financing from money markets rather than deposits. As borrowing becomes cheaper, banks are more willing to lend out money. It is obvious that lack of confidence due to a severe crisis situation cannot be resolved by simply lowering the bank rate but it does instigate a sense of being backed up. A change in bank rate also influences the exchange rate. Normally, a decrease in bank rate should reduce the value of currency which in turn would increase the demand for UK goods and services abroad. However, this is a complex mechanism with various factors involved. According to the latest news, the pound has actually increased and rose above $2 for the first time in two months. 4. Conclusion: A change in bank interest rate has a definite influence on the financial market and the economy. Some factors such as exchange rate are affected quicker while others may take more time. However, it takes around two years for a change in the bank rate to have its full impact on inflation. Therefore, it will be some time before the impact of recent rate change is fully felt. Interest rates are generally set based on what inflation might be over the coming two years and not what it is today, but the current economic situation is an important part of the consideration. Also keeping in mind the recent events and the current market conditions, it is very difficult to provide an accurate forecast. With prices soaring, the Bank of England has decided to leave rates at 5.25% for now to curb rising inflation. Under the current market conditions, this will obviously put more pressure on homeowners. Property prices have continued to fall with property experts continuously propagating on further rate cuts. It is important to note that previous strong rise in property prices was sustained by a boom mentality of bidding up prices to avoid missing out on future house price gains with little consideration for interest rate costs. This might apply again when prices are falling and lowering interest rates might not support a crumbling housing market. According to the weighted average of 20 forecasts in a Bloomberg survey, it is expected that the Bank of England is likely to lower the rate to 5% by midyear and by 4.75 % by the end of the third quarter (Cutler 2008). This are simply forecasts and the actual decision by the Bank will depend on the market conditions at that time which are highly unpredictable at the moment. 5. References: BBC. (2007) 'The US sub-prime crisis in graphics'. [Online]. Available: http://news.bbc.co.uk/1/hi/business/7073131.stm [Accessed on 9 March 2008] Cutler, K., (2008) 'U.K. Gilts Post Biggest Weekly Gain in Decade on Credit Losses'. [Online]. Available: http://www.bloomberg.com/apps/newspid=20601102&sid=a524582mQ_n8&refer=uk [Accessed on 9 March 2008] www.bankofengland.co.uk [Accessed on 9 March 2008] Read More