Picture of British money

Dr Robert Gausden, Senior Lecturer in Economics, examines whether the turmoil in the global banking sector will mean the Monetary Policy Committee decides to push interest rates even higher when it meets on Thursday (23 March).

Robert Gausden

5 minutes

On 6 May 1997, the Bank of England was granted a long-sought-after independence by the Labour Government. The creation of the Monetary Policy Committee (MPC) was formalised under a new Bank of England Act of 1998. The MPC is comprised of five Bank officials and four external experts. The latter are appointed by the Chancellor of the Exchequer to sit on the Committee for an initial three years. On occasions, an external member of the Committee has been permitted a second term.
 

What does the Monetary Policy Committee do?

The MPC meets approximately every month to decide upon suitable monetary policy. As set out in the aforementioned Act, the remit of the MPC is to maintain price stability and, subject to that objective, to support HM Government’s economic policy, including its aims for growth and employment. At least once every twelve months, the Chancellor is required to provide an interpretation of price stability. Most recently, the Chancellor, Jeremy Hunt, has confirmed in a letter to the Governor of the Bank of England, Andrew Bailey, that the target rate of annual consumer price inflation is 2 per cent. The policy tools which are available to the Bank of England are the base rate of interest and quantitative easing or tightening.

From March 2009 to January 2020, there occurred little variation in the base rate of interest. As a response to the financial crisis, the rate of interest fell to 0.5 per cent in March 2009 and remained at this level until August 2016. The rate of interest changed only modestly over the next three years such that, by January 2020, it stood at 0.75 per cent. As a response to the Covid-19 pandemic and the imposition of lockdowns, the decision was taken to drop the base rate to 0.10 per cent in March 2019. The interest rate stayed at this low level until December 2021, when it was increased to 0.25 per cent. From December 2021 to February 2023, there have been a succession of base rate rises of different magnitudes, which have resulted in the rate of interest currently being equal to 4 per cent, which is its highest value since October 2008.

What are the reasons for tightening monetary policy?

The reason for the recent tightening of monetary policy is the high rate of price inflation that the UK has been experiencing. The annual rate of consumer price inflation was only 0.4 per cent in February 2021. However, this rose progressively to a peak of 11.1 per cent in October 2022.

The origin of this increase in price inflation is generally considered to be the relaxation of monetary policy across the world in response to the pandemic. Adding to the upward pressure have been supply-chain disruptions following Covid-19 and the surge in energy and food prices as a consequence of the invasion by Russia of Ukraine.

However, over the past three months, the annual rate of consumer price inflation has come down in the UK. Indeed, the most recently published figure by the Office for National Statistics is 10.1 per cent for January 2023. This raises the question of whether the MPC will be seeking to advocate a further rise in the base rate of interest when it meets on 23 March 2023.

If we examine this issue from a voting perspective, it should be recognised that two of the members of the MPC did not favour an increase in the rate of interest at the February 2023 meeting. Indeed, the two external members, Swati Dhingra and Silvana Tenreyro, did not support any of the three most recent rises in the base rate. One suspects, then, with price inflation now falling, that these two members will not be advocating a rise in the rate of interest to a value above the current 4.0 per cent.

However, the seven other members seem to have been quite consistent in seeking a tight monetary policy. The suggestion of past voting patterns is that, with price inflation still so far above its target, the majority will propose at least a 0.25 percentage point increase.

Other pressures to consider

Consideration can also be given to cost pressures. It needs to be respected that the wholesale price of gas is currently more than seventy per cent below its peak in August 2022. Also, both petrol and diesel prices fell between December 2022 and January 2023.

However, the Office for National Statistics estimated that, at the beginning of the year, the prices of food and non-alcoholic beverages were 16.8 per cent above what they were twelve months’ ago, and there is a concern that such prices will remain high throughout 2023. Respect also needs to be given to wage increases. Pay growth for the private sector was 7.2 per cent in September to November 2022, compared to only 3.3 per cent for the public sector.

Although these are rates which are well below price inflation, now that the Government is reaching agreements with some of the trade unions, overall wage inflation is likely to be drifting upwards in 2023. Following the policy announcements that were made in the Budget by the Chancellor, Jeremy Hunt, the Office for Budget Responsibility was encouraged to predict that consumer price inflation would be only 2.3 per cent in the fourth quarter of 2023.

With the direction of price inflation being so clearly downwards, there would seem to be a strong justification for the MPC to refrain from increasing the rate of interest any further.

What are other countries doing?

However, when setting monetary policy, the Bank of England needs to be mindful of the actions that are being taken by the other major central banks, notably, the Federal Reserve in the United States and the European Central Bank (ECB) in Frankfurt. The ECB is concerned that price inflation is predicted to be too high for too long. Hence, on 16 March 2023, its governing council took the decision to raise three key interest rates by 50 basis points.

Also, in February 2023, the Federal Reserve Chairman, Jerome Powell, announced a 0.25 percentage point increase in the Federal Funds rate, taking this to 4.5 – 4.75 per cent. Although the extent of the rises in this rate is becoming smaller, monetary policy in the US is continuing to tighten.

A problem that is confronting the Bank of England’s MPC is that if its decisions are seen to be out of step with those taken by the authorities in the US and the European Union then this may have implications for the value of the pound. In particular, if monetary policy in the UK is perceived to be looser than elsewhere then this may cause sterling to depreciate, which will have the effect of raising import prices and stoking inflation.

The decisions taken by the ECB and the Federal Reserve may have the strongest bearing upon how the MPC decides to act on 23 March 2023.