Interest Rates in the UK

Interest rates play an important part in modern day economics. Interest rates in the UK are currently at 0.5%, the lowest they?ve been in the Bank of England?s 315 year history (see http://news.bbc.co.uk/1/hi/business/7817453.stm). But why have interest rates fallen? The answer lies with the Monetary Policy Committee, which decides the interest rates monthly based on the targets set by the UK Government, whereas in the rest of the EU, interest rates is set by the European Central Bank, and by the Federal Reserve in the US.

There is but one target set to the MPC: an inflation rate of 2%, or with a 1% leniency. This target has been set every year since 2004, and looks like it?ll be the standard target for the rate of inflation for quite some time. If the MPC fails to meet this target, the Governor of the Bank of England must produce an open letter (meaning the public is free to view its contents) to the current Prime Minister, explaining why the target was not reached. Mervyn King has been the Governor since the MPC was introduced in 1997, and was required to produce an open letter to Gordon Brown on the 16th April 2007, addressing why the MPC failed to meet the target rate of inflation.

The rate of inflation can be controlled by using monetary policy (hence the MPC), which primarily uses interest rates to steer the UK economy towards the targets set by the Government. However, there is a one year ?lag? on the rate of inflation when interest rates are changed. When interest rates are pushed up, total spending in the economy falls (it?s now more expensive to borrow money). Since less things are being bought, prices fall to encourage spending, leading to a lower rate of inflation. On the other hand, if interest rates fall, borrowing becomes cheaper and therefore more people will want to borrow money and buy things, pushing prices up, increasing the rate of inflation.

There was almost no way that the MPC could have predicted the current recession one year in advance, which is why interest rates are currently in the extreme. They?ve been hammered down to make absolutely certain that the inflation rate (one of the four most important factors in an economy) stabilises as soon as possible.

Due to the reasonable predictability in the economy (macroeconomics uses data to try and forecast changes in the economy, much like meteorologists and the weather), the MPC has been within the target range for inflation every time bar once. By looking at this graph (see http://www.omegaaccountancy.co.uk/bank-of-england/base-rates.html), you can see that the rate of interest has fluctuated constantly for the last 30 years, but has become more stable since 1997 and the introduction of the MPC.

This graph doesn?t display statistics from 2009 and most of 2008, where the interest rate will plummet to near the bottom of the graph. As you can tell by the graph, the base interest rate has barely been below 4% in the last 30 years, so it will go up again at some point in the next couple of years.