The Bank of England: an introduction to its role and responsibilities

Summary

In this article, we help explain the following:

  • The role of the Bank of England in maintaining monetary and financial stability for the United Kingdom
  • The definition of the Base Rate and the process used by Central Banks to set it
  • How Avamore believes a better harmony between monetary and fiscal policy is needed to deal with market uncertainty and avoid recession

Introduction

The recent decision of the Bank of England (BoE) to further reduce the interest rates by 25bps to a record-low 0.25% and to increase its bonds purchase program to £435bn ( including for the first time £10bn of corporate bonds) has been seen as an appropriate response to dealing with the post-Brexit market uncertainty. The BoE’s Governor stated that he is trying to anticipate a slowing in demand rather than reacting to one that has already happened.

But what is the BoE and what does it actually do?

It performs two primary functions:

1. Monetary Stability
Monetary stability specifically relates to stable market prices, but also to confidence in the currency. Stable prices are maintained by seeking to ensure that general marketplace price increases meet the Government’s inflation target of 2%. The BoE aims to achieve this goal by adjusting the base interest rate, which is decided by the Monetary Policy Committee (MPC), and through its communications strategy, such as publishing yield curves.

2. Financial Stability
Financial stability relates to the oversight of the financial system so that there is trust and confidence in financial institutions, markets, infrastructure, and the system as a whole. It requires an efficient flow of funds in the economy and confidence in all the institutions involved. Depositors, need to know for example that their savings are safe and that banks and other lenders are acting responsibly.

In general, maintaining financial stability involves protecting against threats to the whole financial system, such us money laundering, bribery and corruption. Bodies responsible for financial stability are the Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA).

What is the Base Rate?

The base rate is the interest rate at which the BoE lends money to commercial banks, usually in the form of very short-term loans. Even if commercial banks are free to set their own interest rates for borrowing, overall the rates charged on loans and offered on savings tend to be derived from the base rate. This allows central banks to use base rates to encourage or discourage spending, depending on the state of the economy. Lower bank rates can help to expand the economy by lowering the cost of funds for borrowers. With the cost of borrowing low and the benefit from saving minimal, consumers should, in theory, be encouraged to spend money instead of saving it, giving a boost to businesses and the economy. On the other hand, higher base rates help to reign in the economy when inflation is higher than desired and there is a perception that the economy is becoming overheated.

Understanding how Central Banks set the Base Rate

Each month the MPC meets to analyze the latest news on the UK and world economy aiming to set the most appropriate interest rate. Factors considered when making rate decisions include: GDP growth and the size of the output gap (so-called ‘spare capacity’), flows in bank lending and consumer credit figures, unemployment rate, equity markets and house prices, consumer and business confidence, global foreign exchange markets. The primary way in which the BoE influences aggregate demand and inflation is via the lending and borrowing rates charged in the financial market (so-called ‘base rate’).

Avamore perspective

The Brexit shock on the macroeconomic environment is the biggest threat to the work of the BoE. To reduce the chance of a recession next year, the Bank decided to cut interest rates to 0.25% and to introduce additional liquidity in the market in the coming months. Without going into negative interest rates (which the Bank has indicated it prefers not to and which would bring its own set of problems) there is a concern that the Bank has exhausted its firepower and the Governor himself has alluded to this.

We believe the approved monetary measures must be followed by a comprehensive package on the fiscal side in order to be as effective as possible.

Therefore in the current environment where further measures by the BoE are limited, the new Chancellor’s Autumn statement will be of particular importance. Our guess is a package of policy changes including targeted tax reductions and spending on large infrastructure projects are the most likely.

About Avamore Capital:

Avamore Capital is a special situations lender that provides loans to property traders, property developers, property investors, and other property entrepreneurs. Loan sizes are between £0.5m and £5m with larger loans possible in conjunction with its partners. AvamoreCapital provides a flexible approach, quick feedback and very fast drawdown, subject to due diligence.

For further information please visit www.avamorecapital.com or contact Rocco Versace at rv@avamorecapital.com

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