Monetary Tools

Monetary policy in the UK and the US is conducted by the Bank of England and the Federal Reserve, respectively. While on the surface, monetary policy appears uniform across all nations; this is far from the truth – with different monetary tools at the disposal of the various Central Banks globally. Such is the case with the two countries mentioned above; the Federal Reserve has traditionally set reserve requirements for banks. Commercial banks in the UK have been free for decades to choose the percentage of reserves they hold with the Central Bank.

Bank Rate

The Bank of England and the Federal Reserve set a Bank Rate to influence interest rates. The official Bank Rate in the UK was cut from 0.75% to 0.1% at the start of 2020. The Federal Reserve reduced its bank rate (more commonly referred to as the discount rate in the US) from 2.25% to 0.25% in March 2020. The Bank Rate determines the percentage of interest paid on the reserve deposits of commercial banks. At the same time, the Bank Rate also determines the interest charged to banks for reserve loans. Thus, the rate of interest at which commercial banks receive on their deposits is equal to that of the interest rate paid on loans when they borrow from the Central Bank. Higher Bank Rates incentivise commercial banks to deposit more reserves with the Central Bank, rendering them less able to lend as most loans needed to backed with reserves, leading to higher interest rates for loans. Likewise, commercial banks increase the interest paid on deposits in savings accounts to incentivise customers to deposit more money with them so that they have more reserves to deposit in the central bank. The converse is true with lower bank rates.

Adjustments to the bank rate can influence the actions of consumers. Cuts to the bank rate usually occur during recessionary periods with sluggish economic growth, as they promote lending, and thus more spending usually ensues. In this way, lower bank rates help borrowers and put savers at a disadvantage, as the latter group receive less interest on their bank deposits due to the effect, as mentioned earlier, of bank rates on the deposits of commercial banks. However, low bank rates bear the risk of higher inflation, as more demand and consumer spending can drive nominal spending above the potential output of an economy: demand-pull inflation. Reductions in the Bank Rate occurred following the Great Recession, with the bank rate in the UK cut from 5% to 0.5% in 2008.

Conversely, higher bank rates tend to promote deflation whilst at the same time helping savers. As commercial banks receive more money on their reserve deposits with the Central Bank, they are incentivised to hold more as a pose to lending their funds out. Thus, borrowers are disadvantaged, as higher interest rates for borrowing come with higher bank rates. This reduces spending and therefore causes price growth to fall. Raising Bank rates was implemented in both the UK and the US towards the end of the 1970s and the start of the 1980s to counteract the out-of-control inflation experienced at the time. Bank rates in the UK and the US rose to levels as high as 16% and 14% in 1979.

OMO & QE

The most common practice used by Central Banks to influence interest rates in the economy is open market operations. This involves the Central Bank buying or selling securities, such as government bonds (more commonly referred to as gilts in the UK). By purchasing securities, the Central Bank increases the money supply, driving up the demand for government bonds and their prices, thereby reducing real interest rates as bond yields are inversely proportional to bond prices. The converse applies when the Central Bank sells these securities, reducing the amount of money in circulation, thus increasing real interest rates.

Quantitative easing is a more extreme version of the expansionary side of Open Market Operations. Quantitative easing involves much more government bonds being purchased by the Central Bank and a broader range of securities, including corporate bonds. This process increases the money supply, encouraging bank lending by reducing real interest rates. Quantitative easing was first utilised in the UK in 2009, in the depths of the Great Recession. By November 2009, £200 billion of economic stimulus was pumped into the British economy through quantitative easing.

Reserve Requirements

Although commercial banks in the UK haven’t been subject to reserve requirements since 2009, in the US, the Federal Reserve has traditionally enforced commercial banks to hold in their vaults or deposit with the Central Bank a certain percentage of their funds. At the start of the 2000s, the reserve requirement stood at 6%, and central Banks gradually raised this over the decade to discourage banks from lending excessive amounts of money, reaching just shy of 20% for small commercial banks by 2010. However, as of March 2020, the Reserve Requirement in the US has been at 0%. This reduction was implemented to induce the opposite effect – encouraging commercial banks to lend out money, and attempting to stimulate economic growth.

Ultimately, Central Banks have various monetary tools to deal with various situations. Evident during the coronavirus pandemic, Central Banks across the globe have used various monetary tools to try and stimulate economic growth. Monetary policy and the monetary tools that shape it will continue to be the source of economic stimulus during a downturn, with Central Banks likely to experiment with new methods to promote spending and economic growth in the coming decades – as was the case with the introduction of quantitative easing in 2008.