The Monetary Policy Committee (MPC) sets the short-term interest rate at which the Bank of England deals with the money markets. Decisions about that official interest rate affect economic activity and inflation through several channels, which are known collectively as the ‘transmission mechanism’ of monetary policy.
The purpose of this paper is to describe the MPC’s view of the transmission mechanism. The key links in that mechanism are illustrated in the figure below.
First, official interest rate decisions affect market interest rates (such as mortgage rates and bank deposit rates), to varying degrees. At the same time, policy actions and announcements affect expectations about the future course of the economy and the confidence with which these expectations are held, as well as affecting asset prices and the exchange rate.
Second, these changes in turn affect the spending, saving and investment behaviour of individuals and firms in the economy. For example, other things being equal, higher interest rates tend to encourage saving rather than spending, and a higher value of sterling in foreign exchange markets, which makes foreign goods less expensive relative to goods produced at home. So changes in the official interest rate affect the demand for goods and services produced in the United Kingdom.
Third, the level of demand relative to domestic supply capacity—in the labour market and elsewhere—is a key influence on domestic inflationary pressure. For example, if demand for labour exceeds the supply available, there will tend to be upward pressure on wage increases, which some firms may be able to pass through into higher prices charged to consumers.
Fourth, exchange rate movements have a direct effect, though often delayed, on the domestic prices of imported goods and services, and an indirect effect on the prices of those goods and services that compete with imports or use imported inputs, and hence on the component of overall inflation that is imported.
Part I of this paper describes in more detail these and other links from official interest rate decisions to economic activity and inflation. It discusses important aspects that have been glossed over in the summary account above — such as the distinction between real and nominal interest rates, the role of expectations, and the interlinking of many of the effects mentioned. There is also a discussion of the role of monetary aggregates in the transmission mechanism.
Part II provides some broad quantification of the effects of official interest rate changes under particular assumptions. There is inevitably great uncertainty about both the timing and size of these effects. As to timing, in the Bank’s macroeconometric model (used to generate the simulations shown at the end of this paper), official interest rate decisions have their fullest effect on output with a lag of around one year, and their fullest effect on inflation with a lag of around two years. As to size, depending on the circumstances, the same model suggests that temporarily raising rates relative to a base case by 1 percentage point for one year right be expected to lower output by something of the order of 0.2% to 0.35% after about a year, and to reduce inflation by around 0.2 percentage points to 0.4 percentage points a year or so after that, all relative to the base case.