Bitesize Economics: Interest Rates

Every six weeks the members of THE Bank of England’s Monetary Policy Committee commute – I’d imagine from homes in Surrey (train to Waterloo then Waterloo & City Line) or Hampshire (train to Waterloo then Waterloo & City Line) or Sussex (train to Victoria then District/Circle Line to Mansion House and a short walk) – to Bank, where the BoE is situated, right next to the station. The members meet – every six weeks – to vote. To vote on what rate will be set as the Bank Rate.

Required background knowledge – BoE, BR, INF:

• The BoE was formed in 1694 to help finance the war vs. France. Its modern purpose is to be the bank of banks (and the government). The idea is to separate the monetary from the fiscal: a government with the ability to issue debt and then basically set the interest on that debt was too much power for said government to have. The BoE would “work together” with the gov. to “manage” the economy, with the ability to keep gov. raising of money via debt issuance in check by kicking them up the arse with interest rates
• In theory. In reality, the BoE does what the gov. tells them to. It’s sort of like driving with your mate’s foot on the break and telling him when to contract his right quadricep and gastrocnemius. Why not just have your foot on the break instead? You would certainly have more control of the vehicle. But if you’re drunk or falling asleep or looking at a nice BMW overtaking you on the M3, it might be beneficial to have a second pair of eyes on the road and an external foot on the brake. That’s the idea
• The goal of the BoE – the party line – is to maintain a certain level of inflation, measured by growth in the Consumer Price Index, which is a basket of goods designed to sufficiently encapsulate the average consumer’s average consumption. Hence monitoring the change in the price of this basket will measure how much the nominal cost of living for the average person in the United Kingdom is changing
• The BoE should use the BR to maintain INF at 2% – the target set by gov. This target has always been around 2%, regardless of who is occupying No. 10 DS and where they are on the Hawk/Dove spectrum and how much Keynes vs. Hayek they read and ingested at Oxford. Straying by more than +/-1p.p from this target will result in a letter from the BoE addressed to gov. explaining the Oopsie Daisy and plans to correct it
• 2% sounds like a good number, right? Congrats – you just obtained the same understanding as the MPC, George Osbourne, and this author have of why two point zero percent is a good inflation level to target. Reasons for 2%: “balances the benefits and costs of inflation”, “low and stable inflation”,  “goldilocks”, “if it ain’t broke, don’t fix it baby”, etc.

Let’s say Andy and the gang decide to raise the BR by 0.5 percentage points/3.5%–>4.0%/fifty basis points/50 bps.

Required background knowledge – retail banks:

• Retail banks traditionally make profit by taking deposits, paying interest on those deposits at rate X%, and doing various financial things to earn X+Y% on those deposits, making themselves a nice Y% return. Y-operating costs = profit. It’s a nice business
• To be a bank in the UK, you have to apply for a banking licence. You have to meet strict capital requirements. You have to submit to stringent auditing processes. You have to make sure you’re being fair to customers – according to the Financial Conduct Authority – and that your business plan is sound – according to the Prudential Regulation Authority. Make money but not too much. PRA slaps one cheek whilst FCA slaps the other
• Licensed banks in the UK are allowed to deposit at the BoE and receive the BR on these deposits (commercial deposits/operational balances)
• RBs deposit some of your deposits with the BoE and earn the BR% on these deposits
• RBs lend some of your money to other people in the form of loans. Personal loans and mortgages, mostly

When the BR increases, banks receive a larger return on money deposited at the BoE:

1. Some banks think hold on wait a second we can increase our own deposit rate and get more market share. Get more deposits. They raise their interest rates on current and/or savings accounts.
2. It’s a (slow and not THAT comprehensive (most people don’t give fuck about interest rates, they just want to know their money is secure or they like the website or app or they like Deborah from the local branch outlet. Old, established banks don’t have to raise their rates)) race to the top. Rates rise across the board. The interest rate you receive on your savings probably increases.
3. Banks get squeezed. X has increased but (the lending return part of) Y stays the same. They raise Y. Loans are now more expensive. They are offered at higher rates. The APR on personal loans and new mortgages increases. The i/r on VR mortgages, which have interest rates tied to the BR, increases.