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Monetary Policy - Monetary Policy Committee

Theory 1 - Monetary Transmission Mechanism - what are the links between the interest rate and inflation?

Stage 1

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Stage 1 of the transmission mechanism is the way in which interest rate changes are transmitted through to markets. Various different markets are affected. The money markets, where all financial assets are traded, will be directly affected, but other markets will also be indirectly affected. The housing market, the stock market and bond markets will be affected and the value of these items may change. International markets for goods and services will be affected through the exchange rate. On top of all this, any interest rate change may affect the expectations of firms and individuals and the level of confidence in markets.

Many of these effects are difficult to work out exactly and often will depend on other circumstances, but below is some more detail on how each market is affected. This analysis assumes that markets don't expect the rate change to be reversed in the near future.

Money markets

Both short-term and long-term interest rates will be affected. As soon as a rate change is announced, the banks will usually change their 'base rates'. Most of their other interest rates are calculated from this 'base', and so this will have an immediate effect on the interest rates they are charging to borrowers and paying to savers. Mortgage rates will often change fairly quickly as well, depending how much the official rate has been changed by.

The effect on long-term interest rates is slightly more complex and depends on what markets expect to happen to the rate in the future. Long-term interest rates tend to be an average of current and future expected rates and so long-term rates may go either way. For more detail on this see the further work section.

Asset prices

Higher interest rates will tend to reduce the prices of various assets. Shares (equities) are likely to be affected. The markets will anticipate the effects of the higher interest rates on the level of spending, and allow for this in the way that they value the shares of companies. Any future returns from shares will also be discounted by a larger amount, and so be worth less. This will reduce the value of the shares. For more detail on this effect see the further work section.

Bond prices will also be affected as they are inversely related to interest rates. For more detail on this effect see the further work section.

The rate of increase of house prices will also tend to slow down (or perhaps even fall). To buy a house, most people have to borrow. The higher the level of interest rates, the more expensive this mortgage will be. This will tend to reduce the demand for housing, and as with any other market, a fall in demand may reduce prices.

Exchange rate

Higher interest rates may well increase the demand for sterling. Overseas investors will be attracted to the UK by higher relative interest rates, and so there may well be an inflow of investment. This increased demand may, as with any other market, push up the price of sterling. We normally term this an appreciation in the exchange rate. This appreciation will increase the price of exports overseas, and make imports appear relatively cheaper. However, these price effects may take some time to work through.

Expectations / confidence

Interest rate changes will affect the expectations of a variety of groups. Individuals will be affected as they see their financial position affected. They may hold shares and other forms of savings and will be quite likely to be borrowers. Any interest rate change may affect their perception of how well off they are, and are likely to be in the future. Firms will also be affected, as they usually need to borrow to invest. They also depend on the state of the economy for the demand for their products and services. Their profitability may therefore be affected by any interest rate change. Financial markets will also be affected.

The exact effect on expectations and confidence depends on how people interpret the rate rise. If the MPC raise interest rates, people may think that the MPC expect the economy to grow faster in the future. This could boost confidence. On the other hand, it may signal to people that the MPC want to slow the economy down. This would not be good news and is likely to dent confidence.