Setting the base rate and the transmission of monetary policy

Overview

Base rate, exchange rate enter the interest rate decision and credit growth.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is the base rate, and why does it matter so much when it applies directly to so few contracts?

   Model answer

   The base rate is the interest rate a central bank sets on the reserve balances that commercial banks hold with it, and therefore the rate at which the banking system's most liquid funds are remunerated. Almost no household or firm borrows at it directly, but it matters because it fixes the marginal cost and return of funds for every bank, so it becomes the benchmark from which all other rates are priced. Tracker mortgages, overdrafts, business loans, savings accounts and the yields on short-dated government debt all move with it, and expectations of where it will go next drive longer-term interest rates, asset prices and the exchange rate. It is therefore the single price from which the whole structure of interest rates in the economy is built.

2. 2

   Why does a central bank set the price of money rather than its quantity?

   Model answer

   Targeting a quantity requires a stable relationship between that quantity and spending, and the demand for money proved unstable once financial innovation, competition between banks and new payment technologies changed how much money people wish to hold at any given income. When the relationship shifted, hitting a money target produced wildly variable interest rates without delivering the intended inflation outcome. Setting a rate instead lets the quantity of money adjust to demand at that price, which is far more predictable in its effect on borrowing, spending and the exchange rate, and it is easily understood and communicated, which helps anchor expectations.

3. 3

   Why does a central bank respond to the inflation it forecasts rather than the inflation it is currently observing?

   Model answer

   A change in the policy rate takes time to work: it affects market rates and confidence within months, spending over the following year, and prices only after that, with the largest effect on inflation typically arriving one and a half to two years later. Acting on today's inflation would therefore deliver the effect at a time when conditions have already changed, and would tend to add to the swings rather than damp them. The committee therefore forms a view of where inflation will be at the horizon over which its decision bites, and sets the rate to bring the forecast to target at that point, which is why rates can be raised while inflation is still low, or held while it is still high.

4. 4

   How does the amount of spare capacity in an economy influence the setting of the base rate?

   Model answer

   Spare capacity means that output is below what the economy can sustainably produce, with unemployed workers and idle plant. When it is large, extra demand can be met by using those resources, so it raises output rather than prices, and inflationary pressure from the domestic economy is weak; that argues for a lower rate. When capacity is exhausted, extra demand meets a supply that cannot expand, so firms bid for scarce labour and materials and raise prices; that argues for a higher rate. Judging spare capacity is one of the hardest parts of the decision, because sustainable capacity is not directly observable and the estimate is revised after the event.

5. 5

   Why does a central bank watch the labour market closely when setting interest rates?

   Model answer

   Labour is the largest single cost in most of the economy, so wage growth is the main domestic driver of inflation. A tight labour market, with low unemployment, high vacancies and employers reporting recruitment difficulty, means workers can bargain successfully for higher pay, and if pay rises faster than productivity, unit labour costs rise and firms pass them into prices. The labour market is also a better real-time indicator of the pressure of demand than measured output, which is revised heavily. The key comparison is between wage growth and productivity growth: pay rising in line with productivity is consistent with the target, while pay running well ahead of it is not.

6. 6

   Why do inflation expectations matter to the base rate decision?

   Model answer

   Expected inflation feeds directly into today's inflation, because wage bargains and price lists are set for periods ahead, and both sides build in what they expect prices to do. If expectations stay anchored at the target, a temporary shock to prices passes through and fades. If expectations drift up, workers demand compensation and firms raise prices in anticipation, so the shock becomes self-perpetuating and a much larger rise in the policy rate, with a much larger loss of output, is needed to bring inflation back. A central bank may therefore raise rates in response to a rise in expectations alone, and will place great weight on acting decisively enough to demonstrate that the target still binds.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.