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How Interest Rates are Set

Although many people find the technicalities of interest rates, inflation and other economic factors not only very difficult to understand but also of little interest, these elements are integral in determining the domestic economic status of Great Britain. Interest rates affect bank accounts and investments as well as everyday purchases, and a high level of inflation would be very detrimental to the country’s stability, both financially and politically. Currently in the United Kingdom, it is the Bank of England which holds the responsibility of setting interest rates. It was in May of 1997 that the decision was first made to hand sole operational independence to the Bank of England in terms of deciding on interest rates. This decision was manifested in the Bank of England Act of 1998.

Within the Bank of England it is actually the Monetary Policy Committee which is responsible for the task of setting interest rates, and they are led by a governor. Although officially declared as ‘independent’ in this role, the Monetary Policy Committee is still very much accountable to the Parliament as well as the general public, and they are depended on to act in the very best interests of the country and population. The principle objective of the Bank of England is to deliver price stability and low inflation, thus giving the people reason to place their trust in the country’s economic status. In general the Bank of England has had a very strong record since they were granted operational independence. It is a part of the interest rate process, that should the Bank of England miss the government’s inflation target by more than 1% either above away, the Committee should write a letter to the Chancellor of the Exchequer explaining why the target was not realised and offering reasons for the problem. However, as of yet this has not been necessary, since the inflation targets have not been over or under shot by more than 1%.

The government will set an inflation target each year in the annual budget report, and the Bank of England will then set their interest rates accordingly, hoping to best reach this target. Of course each year the inflation target and therefore the interest rates will vary according to several different factors, such as employment rates and any domestic economic growth. Of course it is not expected for the target to be constantly held for an entire year, because this is not actually possible and more importantly not exactly desirable. To maintain the same inflation target would mean that in context of constantly changing economic conditions, interest rates would also have to fluctuate accordingly. Interest rates which are constantly changing to try and maintain an inflation target set by the government would result in a very volatile financial status and cause many people to become distrusting of the economy.

There are of course provisions for the government to take control of the interest rates, should it be concluded that this would be in national interests. In certain extreme circumstances the government can intervene and give instructions to the Bank of England relating to interest rates, but this is only for a very limited period. So far the Bank of England has proven to be a very reliable controller of the domestic interest rates, and have successfully met inflation targets for more than five consecutive years ensuring the domestic economic stability of the United Kingdom.