The Role of the Central Bank

The Bank of England

Central bank: the bank that manages a country's currency and interest rates, and oversees its banking system. In the UK it is the Bank of England.

The Bank has two main aims: monetary stability, meaning low and steady inflation, and financial stability, meaning a banking system that keeps working in bad times. A separate committee handles each.

The Monetary Policy Committee and Bank Rate

Bank Rate: the interest rate the Bank of England pays commercial banks on the money they keep with it overnight. It is also called the base rate or the official interest rate.

The Monetary Policy Committee (MPC) sets Bank Rate. It has nine members: five from inside the Bank and four outside experts. It announces its decision eight times a year, and each member has one vote. The Bank has set rates without government involvement since 1997.

Bank Rate matters because the rest of the economy's interest rates follow it. If the Bank pays more on banks' deposits, they will only lend to households and firms at higher rates too. So a change in Bank Rate soon changes rates on new mortgages, business loans, overdrafts and savings accounts.

Using Monetary Policy to Control Inflation

The government sets the MPC a target of 2% CPI inflation. If inflation misses it by more than one percentage point either way, the Governor must write an open letter to the Chancellor explaining why and what the Bank will do.

When inflation looks set to rise above target, the MPC raises Bank Rate:

• Households: mortgage and loan repayments rise and saving pays more → less income to spend → demand falls.
• Firms: borrowing costs more → fewer projects are worth funding → investment falls.
• Prices: lower aggregate demand → firms find it harder to raise prices and workers to win big pay rises → inflation slows.

A cut works the other way to lift demand when inflation is heading below target. When Bank Rate is already close to zero, the Bank can use quantitative easing instead. Both tools, and the full chain of effects on aggregate demand, are in unit 4.4.2.

It takes around 18 to 24 months for a change in Bank Rate to have its full effect. So the MPC sets rates for where it expects inflation to be in two years, not where it is today.

How well this controls inflation depends on:

• The cause of the inflation: higher rates reduce demand. They cannot make imported energy or food cheaper, so cost-push inflation is cut only by squeezing demand harder, at a cost to output and jobs.
• Time lags: many homeowners have fixed-rate mortgages, so a rise reaches them only when their deal ends. A forecast that turns out wrong can leave rates too high for too long.
• Credibility: if firms and workers believe the Bank will hit 2%, they set prices and pay claims accordingly, and inflation falls with smaller rate rises.

Regulating the Banking Industry: the Financial Policy Committee

Financial Policy Committee (FPC): the Bank of England committee that looks for risks to the financial system as a whole and acts to reduce them.

The FPC does not supervise individual banks. That is the job of the Bank's Prudential Regulation Authority (PRA), while the separate Financial Conduct Authority (FCA) checks that firms treat customers fairly. The FPC looks for systemic risk: problems, such as a lending boom, that could hit many banks at once.

Its main tools are:

• Capital buffers: the FPC can make banks hold extra capital, money from shareholders that absorbs losses, when risks are building. In a downturn it can release the buffer so banks keep lending.
• Limits on risky mortgages: it caps the share of new mortgages lenders can make at 4.5 times or more a borrower's income.
• Stress tests: each year the Bank checks whether the largest banks could survive a severe recession. Those that fall short must strengthen their finances.

Tighter rules involve a trade-off: the FPC raises the capital buffer → banks are safer but have less to lend → credit costs a little more → slightly less investment and spending. Looser rules risk the kind of lending boom that ended in 2007-08 (unit 4.5.4).

Banker to the Banks: Lender of Last Resort

Commercial banks hold accounts at the Bank of England, just as firms hold accounts at a high-street bank. They use them to settle payments with each other. That makes the Bank of England the banker to the banks.

Lender of last resort: a central bank lending to a commercial bank that is short of cash and cannot borrow anywhere else.

A bank lends most of its deposits out for years, so it never has enough cash to repay every saver at once. If savers fear for the bank and all try to withdraw together, a bank run, even a sound bank can run out of cash.

In September 2007, savers queued outside Northern Rock branches after it asked the Bank of England for emergency funds.

When the Bank steps in:

• Savers: the bank can pay out every withdrawal → panic subsides → savers stop queuing.
• The wider economy: one bank's failure cannot spread to others it owes money to → banks keep lending to firms and households.

The case for it depends on:

• Short of cash, or bust: the role is meant for banks with a cash shortage, not banks whose loans have gone bad. The Bank lends only against good collateral, and charges more than normal for it.
• Moral hazard: if banks expect to be rescued, they may take bigger risks. That is why the lender of last resort comes with regulation from the FPC and PRA.