Economics IA: The Bank of England’s 2024 Interest Rate Cut

Commentary

The Article and Key Terms

On August 1, 2024, the Bank of England’s Monetary Policy Committee (MPC) cut Bank Rate by 0.25 percentage points, from 5.25% to 5%. It was the first cut since March 2020 and passed by five votes to four, as policymakers disagreed about whether inflationary pressure had eased enough (Milliken et al., 2024). Bank Rate is the interest rate the Bank pays commercial banks on the money they hold with it, so it sets the base for the rates that households and firms pay on loans and earn on savings. Changing it is monetary policy, which works through aggregate demand (AD), the total planned spending on an economy’s goods and services. The Bank targets inflation, the rate at which the average price level rises, of 2%. Inflation had fallen from a 41-year high of 11.1% in October 2022 to 2% in May and June 2024. This commentary uses the key concept of economic well-being to judge whether the cut is likely to leave people in the UK better off.

Why Interest Rates Rose

The cut ends a long period of contractionary monetary policy. After the pandemic, spending recovered faster than supply, and energy prices rose sharply in 2022, so inflation climbed far above target. Between December 2021 and August 2023 the MPC raised Bank Rate 14 times, from 0.1% to 5.25%. Higher interest rates raise the cost of borrowing and the reward for saving, so consumption and investment, two components of AD, fall. In Figure 1, AD shifts left from ${\mathrm{AD}}_1$ to ${\mathrm{AD}}_2$. Real GDP falls from $Y_1$ to $Y_2$, and the average price level falls from $P_1$ to $P_2$; in practice prices rise more slowly, so inflation falls. The cost is that output is now below its full-employment level ($Y_f$), a negative output gap, and unemployment tends to rise.

Effects of the Rate Cut

Cutting Bank Rate is an expansionary move, although at 5% policy is still restrictive. Banks pass the lower rate on to variable-rate mortgages and new loans, so households have more disposable income and firms find more investment projects worthwhile, while saving becomes less attractive. In Figure 2, AD shifts right from ${\mathrm{AD}}_2$ to ${\mathrm{AD}}_3$: real GDP rises from $Y_2$ to $Y_3$, closer to $Y_f$, while the price level rises only a little, from $P_2$ to $P_3$, because the economy has spare capacity. The multiplier makes the effect larger: extra spending becomes income for other firms and workers, who spend part of it again, so national income rises by more than the first increase in spending.

Economic Well-Being

Economic well-being refers to people’s prosperity, economic security and quality of life. The cut can raise it in three ways. Borrowers, especially mortgage holders whose repayments rose sharply in 2022 and 2023, keep more of their income. Firms that invest create jobs, which limits the rise in unemployment that the Bank expects. Low and stable inflation also protects real incomes, which fell in 2022 when prices rose faster than wages; by cutting only slightly, the Bank supports spending without putting that at risk. Not everyone gains, however: savers and retired people who live on interest income lose, so the policy redistributes income from savers to borrowers.

Evaluation

Several factors limit the effect of the cut. First, monetary policy works with long time lags: the Bank of England (n.d.) says it can take around 18 to 24 months to have its full effect, and households on fixed-rate mortgages will feel the cut only when their deal ends. Second, a quarter-point cut is small, and households and firms that lack confidence may save rather than spend. Third, the four members who voted against feared that inflation would prove persistent: services inflation was 5.7% and private-sector pay growth 5.6% (Bank of England, 2024). If the Bank cuts too fast, inflation could rise again and erode the gains in well-being. Finally, lower interest rates can push up house prices and household debt, and supply shocks such as higher energy prices are beyond the Bank’s control. Monetary policy may therefore need support from supply-side policies that raise productivity and shift LRAS to the right, allowing growth without inflation.

Conclusion

In conclusion, the August 2024 cut is a cautious first step away from contractionary policy. With inflation back at target and unemployment expected to rise, a small cut is likely to raise economic well-being by lowering borrowing costs and supporting jobs, but the gains will be gradual and uneven. The narrow vote and Governor Andrew Bailey’s warning that the Bank must not cut rates “too quickly or by too much” (Milliken et al., 2024) show why it is right to move slowly: a return of high inflation would harm well-being more than a few more months of high interest rates.