Central banks & interest rates

When the Bank of England changes interest rates, the effects ripple out to almost everyone: mortgage holders, savers, businesses planning investment, and the value of the pound abroad. Yet the institution that makes these decisions, and the way a single interest rate can steer a whole economy, are often poorly understood. This topic explains what the Bank of England is, what the base rate does, how changes in it transmit through the economy, and why the Bank was given independence to set rates in 1997.

What a central bank is

A central bank is the public institution responsible for managing a country’s currency, money supply and interest rates. Its core jobs typically include setting monetary policy to keep prices stable, acting as banker to the government and to commercial banks, and helping to safeguard the financial system. It is not a normal bank: ordinary people do not hold accounts there, and its goal is the health of the economy, not profit.

The Bank of England, founded in 1694, is the UK’s central bank. Its two main responsibilities are monetary stability — keeping inflation low and stable — and financial stability. It also issues banknotes in England and Wales and acts as lender of last resort, providing emergency funding to solvent banks that face a temporary shortage of cash, so that isolated problems do not spread into a wider panic.

The base rate and the MPC

The Bank’s central tool is the base rate, also called Bank Rate: the official interest rate it sets. Technically it is the rate the Bank pays on reserves held by commercial banks, but its importance lies in its reach — it strongly influences the rates banks across the economy charge borrowers and pay savers.

The base rate is decided not by one person but by the Monetary Policy Committee (MPC), a nine-member committee that meets regularly and votes on whether to raise, hold or cut the rate. Its remit is to meet the Government’s 2% inflation target, and its decisions are published with minutes explaining the reasoning, which supports transparency and accountability.

The basic logic of monetary policy is straightforward:

Raising the base rate tends to slow the economy and ease inflation; cutting it tends to stimulate spending and growth.

How a rate change spreads: the transmission mechanism

A single interest rate can influence the whole economy because of the monetary policy transmission mechanism — the set of channels through which a change in the base rate works its way through to spending, output and ultimately inflation. Several channels operate at once.

• Borrowing and saving. A higher base rate raises the cost of loans and mortgages and increases the reward for saving. Households and firms borrow and spend less, cooling aggregate demand and reducing inflationary pressure. Lower rates do the reverse.
• Asset prices and wealth. Changes in rates affect the prices of assets such as houses and shares, altering how wealthy people feel and how much they spend.
• The exchange rate. Higher UK rates can attract foreign capital chasing better returns, raising demand for sterling and tending to strengthen it. A stronger pound makes imports cheaper and exports dearer, which can lower inflation but may dampen export demand.
• Confidence and expectations. Rate decisions signal the Bank’s view of the economy, shaping the expectations of households and businesses, which themselves influence spending and price-setting.

Because these channels take time to work — often many months — the MPC must act in anticipation, setting policy for where inflation is heading rather than where it is today.

When the base rate is already very low, the Bank has at times reached for an unconventional tool, quantitative easing (QE): creating new money to buy financial assets, mainly government bonds, in order to push down longer-term interest rates and support the economy. The Bank used QE extensively after the 2008 financial crisis and again in 2020.

Operational independence since 1997

For most of the twentieth century, UK interest rates were ultimately set by the Government. That changed in 1997, when the Bank of England was granted operational independence to set interest rates, a reform formalised in the Bank of England Act 1998.

The distinction is precise. The Bank has operational independence, not goal independence: the Government still sets the 2% inflation target, while the Bank decides how to meet it, free from day-to-day political control. The Bank chooses the means; the politicians set the end.

Why hand this power to unelected officials? The reasoning rests on credibility. Politicians may be tempted to keep interest rates low for short-term political gain — for instance, before an election — even at the cost of higher inflation later. An independent central bank can take a longer view and make a credible commitment to price stability. That credibility helps to anchor inflation expectations: if people trust the Bank to keep inflation near 2%, they set wages and prices accordingly, which makes the target easier to hit.

Independence does not mean the Bank ignores everything but inflation. Its primary objective is price stability, but it is also tasked with supporting the Government’s wider economic aims, including growth and employment, provided this does not compromise the inflation target, alongside its major role in financial stability. The framework is also accountable: the MPC’s votes and minutes are public, and the Governor must explain in writing to the Chancellor if inflation strays far from target. The result is a system designed to be both effective and answerable.