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Bank of England’s contractionary policy and UK economy

This Macroeconomics IB Internal Assessment, formatted in APA style, explores the effectiveness of contractionary monetary policies by examining the Bank of England’s decision to cut interest rates from a 16-year high. The IB assessment example discusses the impact of this policy on inflation and economic well-being, using the key concept of economic well-being to analyze the broader implications for the UK economy. The analysis is based on an article from Reuters, providing a comprehensive examination of the factors leading to the rate cut and its expected effects on various economic sectors.

November 2, 2024

* The sample essays are for browsing purposes only and are not to be submitted as original work to avoid issues with plagiarism.

Title of the Article

Bank of England cuts interest rates to 5% in first reduction

since March 2020

Source of the Article

Reuters

https://www.reuters.com/markets/rates-bonds/bank-england-cut

s-rates-16-year-high-careful-future-moves-2024-08-01/

Date of the Article

August 1, 2024

Date of Commentary

28th August 2024

Word Count

776

Unit of the syllabus that

relates to the article

Macroeconomics

Key Concept

Economic well-being

Bank of England cuts rates from 16-year high, 'careful' on future moves

By Reuters

August 1, 20246:26 AM CDTUpdated 3 months ago

A view of the Bank of England building, in London, Britain, July 3, 2024. REUTERS/Maja

Smiejkowska/File Photo Purchase Licensing Rights opens new tab

By David Milliken, Andy Bruce, and Suban Abdulla

LONDON, Aug 1 (Reuters) - The Bank of England cut interest rates from a 16-year high

on Thursday after a narrow vote in favor of policymakers divided over whether inflation

pressures had eased sufficiently.

Governor Andrew Bailey - who led the 5-4 decision to lower rates by a quarter-point to 5%

- said the BoE's Monetary Policy Committee would move cautiously going forward.

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"We need to make sure inflation stays low, and be careful not to cut interest rates too

quickly or by too much," he said in a statement alongside the decision.

Thursday's decision was in line with the forecast in a Reuters poll of economists but

financial markets had only seen just over a 60% chance of a cut.

Rates have been on hold for almost a full year - the longest period rates have been left

unchanged at the peak of a BoE tightening cycle since 2001 - and this is the first cut in rates

since March 2020, at the start of the COVID-19 pandemic.

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In June, the BoE voted 7-2 to keep rates on hold, and minutes of the most recent meeting

showed the decision to cut rates had been "finely balanced" for some members - echoing

the language used previously when rates were kept unchanged.

None of the policymakers who changed their vote at this meeting - Governor Andrew

Bailey and Deputy Governors Sarah Breeden and Clare Lombardelli - had spoken publicly

about monetary policy since the BoE's last meeting in June.

Speaking opportunities had been limited by an election campaign that ended on July 4,

which brought the Labour Party to power with a large majority.

The BoE said policymakers had been briefed on the government's public sector pay and

fiscal policy announcements this week, but their impact would only be incorporated into

the BoE's forecasts after the Oct. 30 budget.

British consumer price inflation returned to the BoE's 2% target in May and stayed there

in June, down from a 41-year high of 11.1% struck in October 2022.

This leaves British inflation lower than in the eurozone - where the European Central Bank

cut rates in June - and the United States, where on Wednesday, the Federal Reserve kept

interest rates steady but opened the door to a September cut.

INFLATION TO RISE

However, the BoE expects headline inflation to rise to 2.75% in the final quarter of the year

as the effect of last year's steep falls in energy prices fades before returning to its 2% target

in early 2026 and later sinking below.

The long-time lags for interest rates to affect inflation mean the BoE is more focused on

what it sees as medium-term drivers of inflation: services prices, wage growth, and more

general tightness in the labor market.

Services inflation came in well above the BoE's forecasts in June, but the BoE put this

down to "volatile components" and regulated prices that were influenced by high headline

CPI earlier in the year.

Wage growth at nearly 6% is almost double the rate the BoE views as consistent with 2%

inflation but is slowing in line with the central bank's expectations.

The BoE now thinks Britain's economy will expand by around 1.25% this year, revised up

from its previous forecast of 0.5%, reflecting stronger-than-expected growth during the

first half of this year.

Unemployment will rise slightly as high interest rates continue to bear down on growth, the

forecasts showed, reducing upward pressure on inflation.

However, the BoE acknowledged the risk that inflation pressures might prove more

persistent and keep inflation above target for longer than its main forecast.

Before the meeting, financial markets priced in two quarter-point cuts by the BoE this year.

The BoE forecasts were based on market expectations, which show interest rates falling to

about 3.7% by the end of 2026.

Next month, the BoE will also need to decide whether it will continue the 100 billion pound

a year reduction in its bond holdings built up between 2009 and 2020.

In its report on Thursday, the BoE stuck with its assessment that these sales had a limited

impact on the gilt market and that the high level of interest rates gave it scope to fine-tune

monetary conditions if the impact proved greater in the future.

The BoE estimated that its bond sales had contributed 0.1-0.2 percentage points to a 2.75

percentage point rise in 10-year gilt yields between February 2022 and June 2024.

Commentary

The article discusses the decision by the Bank of England to cut interest rates from a 16-year

high. This decision was made after a narrow vote by policymakers (5-4) as they were divided

over whether inflation pressure had eased sufficiently. The interest rate was reduced by a quarter

point to attain 5%. The decision to cut interest rates is a contractionary monetary policy aimed at

inflationary pressure that resulted from expansionary policies that were implemented after the

coronavirus pandemic. The measure has been taken to ease inflation from a 41-year high of

11.1% that struck in October 2022. The key concept discussed in this commentary is economic

well-being. The Bank of England is focusing on protecting the country's economic well-being.

The Bank of England has been fighting inflation using expansionary monetary policy, and the

policies have been successful.

Figure 1: Inflation in the UK Economy

Figure 1 is an illustration of the UK economy after the government used expansionary monetary

and fiscal policy after the effects of the COVID-19 pandemic. The world economy was affected

and the policies used led to a rise in inflation. The UK government used policies that led to

growth in aggregate demand from AD to AD1. The overall price of goods and services in the

economy increased from P1 to P2. The UK economy grew from Y1 to Y2. These policies led to

an increase in inflation to 11.1% in October 2022. Since then, the UK government has been

focusing on curbing the growth of inflation and increasing interest rates with the aim of

increasing the cost of borrowing. Consequently, the flow of money was reduced, and the level of

inflation started falling significantly. Although the MPC was split by five votes to four, it is

evident that many of the members are aware that higher interest rates had serious impacts on

economic growth. By cutting the interest rates, the central bank tries to reduce the cost of

borrowing, hence stimulating investment and consumption. This may result in the fueling of

economic activities and employment and may also smoothen the deleterious impact of economic

downturns. This move reflects a proactive response to the impending economic challenges and

securing financial stability.

Figure 2: The effects of hiking interest rates

Figure 2 illustrates the current state of the UK economy and what warrants the reduction

of interest rates. Higher interest rates lead to increased borrowing costs, which discourages

borrowing for both individuals and firms in the private sector. Economic growth reduces from

Y2 to Y1 because the aggregate demand falls from AD1 to AD2. Prices reduced from P2 to P1.

Consequently, lower economic growth may cause a recession. The UK government's intervention

by cutting the interest rate to 5% will reverse this reaction in the economy.

This policy will benefit the consumers who are individual borrowers. This is because they

will borrow more for consumption. Besides, businesses will borrow more and invest, creating job

opportunities in the UK economy. The multiplier effect will help multiply wealth in the UK,

leading to improved standards of living for residents. The aggregate demand will increase, as

illustrated in Figure 1, and hence, the economy will be expected to expand significantly.

Consumers and mortgage owners will benefit from this policy because they will pay less and,

hence, retain more income. Lower interest rates will promote spending and investment because

there will be no benefit in saving.

Although this policy will effectively bring greater economic well-being, there are many

limitations and risks involved with such interventions. While low interest rates are appealing in

the short run, they have unavoidable consequences in terms of asset bubbles, increasing

household debts, and reduced incentive to work for fiscal prudence. Admittedly, this policy

might be limited beyond the Bank of England by exogenous factors such as disruption in global

supply chains or emerging geopolitical tensions. In the long term, the intervention may lead to

insight into the very problem of inflation, and therefore, there is a need to balance it with other

policies that balance out the effect.

The recent cut in the interest rate by the Bank of England underlines how crucial

government intervention is in managing continuous economic challenges and maintaining

economic well-being. While such actions are essential to keep instability at bay and grow

economies and businesses, they have to be finely calibrated, keeping short-term imperatives in

mind with long-term sustainability. Navigating such intricacies of an advanced global economy,

the interplay between state interventionism and market forces shall thrive.

November 2, 2024

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Academic level:

IB Student

Type of paper:

IB Internal Assessment

Discipline:

Economics

Citation:

APA

Pages:

3 (776 words)

Spacing:

Double