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How Interest Rates are Set

The interest rate that you get on your loan will be of great importance to you, as it is this that determines the cost of your loan, the lower the rate the less it will cost you. So how exactly are the rates of interest determined?

All interest rates, be it for loans or mortgages, are based upon the base rate – which as of 1997 is set monthly by The Bank of England’s monetary policy committee (MPC). Rates of interest affect the economy in major ways, and so the policy and process for deciding on the rate is complex.

The MPC is comprised of the Governor, the 2 Deputy Governors, the Bank's Chief Economist, the Executive Director for Market Operations and 4 external members appointed directly by the Chancellor.

During the process of deciding upon the base interest rates, the MPC studies all the available economic data and looks at a range of domestic and international economic and monetary factors. The main concern for the committee is meeting the target for inflation, keeping this within plus or minus 1% of the set 2% based upon the Consumer Price Index measure.

The Bank and the MPC looks at a range of domestic and international economic and monetary factors, which will have a bearing on inflation over the future. The policy decision also takes account of developments affecting business and commerce throughout the UK. Information on such developments is supplied by the Bank's regional Agencies, located throughout the UK.

If inflation misses the target by more than 1% either side, the Governor of the Bank of England (as Chairman of the MPC) is required to write an open letter to the Chancellor explaining the reason for the divergence, and what action will be taken to bring it back inline with the target.