BoE Policy – Understanding the Bank of England

The Bank of England is the second oldest central bank in existence. Until the end of the WWII, it was arguably the most important central bank in the world, and many tie the Great Depression to its policies under the famous Montague Norman, the last governor of the institution before it was nationalized. Today the Bank of England no longer occupies the lofty position it did among peers prior to the Second World War, but as the controlling authority of the British Pound, and as the central bank of London as an important center of the world of finance, it is still a powerful and carefully watched institution with widespread influence.

The Bank of England is also remarkable for the quality and depth of its publications which often provide great insight into the problems faced by the British and global economies.

Timeline of the history of the Bank of England

The Bank of England was established in 27 July 1694, in accordance with a Royal Charter, as a private enterprise by Scotsman William Paterson. Taking advantage of the dire conditions of the finances of the British Government at that time, Paterson offered a 1.2 million pound loan to the government in return for the privilege of incorporating the lenders as the Governor and Company of the Bank of England with the power to issue banknotes and other long term powers.

In 1781 the bank assumed the character of a bankers’ bank, in addition to being the government’s bank. By the renewed charter of 1781 the Bank of England was obliged to keep enough gold in its reserves to pay its notes on demand.

In 1844 the Bank of England was given the sole rights to the issue of banknotes, but other private banks which had previously acquired this privilege retained it as well. The last of these few remaining private institutions lost this power as a result of being taken over in the 1930s, during the global economic crisis.

In 1870, the bank was given the task of determining the interest rate policy (the bank rate) which is a common duty and privilege of central banks today.

After about 250 years of existence as a private institution, the Bank of England was nationalized by the Labor government of Clement Attlee in 1946.

The next important milestone in the history of the bank came in 1997, under the tenure of Gordon Brown as Chancellor of the Exchequer. According to the Bank of England Act of 1998, the institution’s Monetary Policy Committee was given sole responsibility for setting interest rates with the goal of meeting a target of 2.5% RPI (retail price index inflation. The RPI was later replaced by CPI, and the target was revised to 2% in line with other central banks around the world. Also as part of the 1998 act, the Bank of England was given operational independence over monetary policy decisions.

The Monetary Policy Committee

Equivalent to the Governing Council of the ECB, and the Board of Governors of the Federal Reserve, the Bank of England is governed by a Monetary Policy committee of nine members, including the Governor, two Deputy Governors, the chief Economist, the Executive Director for Markets, in addition to four external members appointed by the Chancellor of the Exchequer. One distinguishing feature of the MPC over its equivalents in Europe and the U.S. is the absence of regional governors: there is no Scottish, Irish or Welsh representative in the Monetary Policy Committee.

The MPC makes decisions on a simple majority basis, and the dissenting votes are regularly publicized along with the minutes of successive meetings. Each member has one vote, and the Governor has the deciding vote in case of tie between committee members.

The MPC meets every month, and on the Friday before the interest setting date, its members receive an extensive briefing on latest economic developments from Bank of England Research Staff. The Treasury is also represented by a non-voting member of the committee who is invited to present opinions, but is not allowed to vote. Although the U.S. Federal Reserve and the Treasury closely communicate on most issues, the Bank of England is unique in requiring the presence of a Treasury (government) representative at its meetings.

MPC meetings last for two days, at the end of which a formal vote is taken by the Governor, and the interest rate decision is announced to the public at 12 noon on the same day. The meeting usually takes place on the Wednesday and Thursday.after the first Monday of each month.

Monetary Policy

The main objective of the Bank of England is maintaining inflation at a level close to, but below 2 percent. To reach this objective the bank adjusts the bank rate to contract or expand liquidity in the financial system. The present monetary policy framework is dependent on the 1998 Bank of England Act which we discussed above. It is important to note that the act, while establishing the independence of the central bank under ordinary conditions, also grants the government to intervene under extreme circumstances if national interest demands it.

In case that the inflation target is missed to either side by more than 1 percentage point (that is, if CPI inflation comes at above 3 percent or below 1 percent, the law instructs the Governor of the Bank to write an open letter to the Chancellor, explaining the reasons behind the failure to reach the target, and establishing the intended remedies for realizing it.

It is estimated that the full impact of an interest rate change is felt approximately one year after the initial policy decision in corporate borrowing, and it may take up to two years for the consumer to feel the full impact of the rate change. Thus, the MPC always keeps the medium term impact of policy decisions on inflation, and not the immediate CPI value.

Bank Rate

The official bank rate is the main rate of the Bank of England. It measures the cost of funds obtained directly from the central bank in exchange for high quality collateral like GILTs. It is important to note that while the bank rate is the key rate of the Bank of England, it is equivalent to the discount rate of the U.S. Federal Reserve and the marginal lending rate of the ECB, since it determines the cost of funds borrowed directly from the central bank itself.

Responsibilities

Apart from the task of determining the cost of pound-based funding, the Bank of England is also legally responsible for maintaining the confidence of the public in the capability and determination of the institution to hold inflation under control. It is also tasked with surveillance of the financial system against possible risks arising from domestic and external factors. To secure the safety of the financial system, the Bank of England is also expected to assume the role of the lender of last resort, in the case of market confidence evaporating.

Publications

As with all modern central banks, the Bank of England sees the correct and timely communication of its policies to the public a central part of its policy mission. The various reports published by the Bank throughout the year can also be very useful and enlightening for forex and stock traders, since they provide useful insight into the bank’s thinking about future interest rate policies.

Financial Stability Report

The financial stability report is published twice a year by the Bank of England’s Financial Stability Board. The purpose of the publication is identifying downside risks to the U.K. economy, and alerting the public and the authorities to the necessary measures which must be taken.

The report is usually structured to include by an overview chapter followed by four analytical sections. The first part examines the latest economic shocks encountered by the U.K. economy in the past six months. The ensuing section overviews the various structural changes in the U.K. financial sector during the same period. The third part, on the anticipated future direction of the U.K. economy, is followed by a concluding section on the necessary actions to be taken by the authorities in order to mitigate risks to economic growth.

As usual, the report is accompanied by detailed charts and a statistical section providing in-depth data on the U.K. and global economies

Trends in Lending

Equivalent to the Survey of Senior Lending Officers of the Federal Reserve, and the quarterly banking survey of the ECB, the “Trends in Lending” report issued by the Bank of England discusses the various developments in the financial sector of the British economy. Unlike other publications of the bank, the Trends in Lending report is mostly comprised of statistics and data collected from other publications of the Bank of England. The data is then evaluated in light of anecdotal surveys of the various sectors of British economy. The report is composed of three parts

Lending to U.K. Businesses

Discussing recent lending trends to U.K. businesses, this section of the report examines the total debt stock of corporations in light of the lending policies of the U.K.’s financial sector. Both the supply and demand side of corporate borrowing is examined, followed by a discussion of corporate loan pricing, and the bond market.

Mortgage Lending

Due to the important of the housing sector to U.K. economy, the mortgage sector has its own section in the trends in lending survey. After examining recent lending data on the basis of information provided by mortgage lenders and banks, the report discusses mortgage pricing, mortgage-backed bonds, and the costs of funding reported by banks and other financial institutions.

Consumer Credit

The financial part of the report is devoted to the analysis of consumer credit data on the basis of demand, availability and pricing.

Inflation Report

The quarterly inflation report of the Bank of England is arguably the institution’s most important publication in terms of both market impact and policy guidance to the general public and the trader community.

The report includes sections on money and asset prices, demand, output and supply, cost and prices, along with a “Prospects for Inflation” section, in addition to various informative indices and charts. The money and asset prices section examines the developments in the financial markets, along with price changes in housing, stock, and related financial markets. The Demand section examines the consumer demand situation, while the output and supply part examines developments in the retail and industrial sectors of the British economy. The costs and prices chapter discusses the wage pressures and the situation of the labor market. And the final Prospects for Inflation part expounds on the committee’s opinion on future inflation.

The report is available at the bank’s website. It is widely anticipated and eagerly studied by all traders and analysts with an interest in the British Pound.

Quarterly Bulletin

The Quarterly Bulletin is the research and analysis publication of the Bank of England. The document examines a wide range of subjects, including current issues, various topical economic and financial matters from both the domestic and international arena. This publication is more useful for traders who seek to understand the big picture behind day-to-day economic developments, and its short-term impact is usually limited.

Conclusion

The Bank of England is still adapting to its new role as an independent institution making policy decisions isolated from other government branches, for the benefit of the public at large. The embarrassing episode where the Governor, Mervin King had to write an open letter to Gordon Brown to explain his failure to reach the bank’s mandated goals is still fresh in memory. In response to 2007-2008 crisis, the bank has also taken some unprecedented steps in lowering the bank rate to its lowest level in history, and printing money directly to revive economic activity. The success or failure of these policies in the future will determine the credibility of the central bank for future generations, and its role in the future structure of the British economy.

Chris Lee

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