The Bank of England raised its key interest rate
- November 4, 2022
- Posted by: OptimizeIAS Team
- Category: DPN Topics
The Bank of England raised its key interest rate
Subject: Economy
Context:
The Bank of England raised its key interest rate by 0.75 percentage point on Thursday, its largest rise since 1989, as it fights a surge in inflation from rising energy prices even as the UK economy slides into an expected recession.
Implication
- Higher borrowing costs will hurt an already weak economy as consumers brace for falling real incomes and rising prices.
- It led to bond sell out and bond yield rose.
What is monetary policy?
Monetary policy is an action that a country’s central bank or government can take to influence how much money is in the economy and how much it costs to borrow.
Monetary policy of England:
- Low and stable inflation is good for the UK’s economy and its main monetary policy aim.It also supports the Government’s other economic aims for growth and employment.
- The UK’s central bank uses two main monetary policy tools.
- Bank Rate-The BoE’s primary monetary policy tool is the bank rate, the interest rate it pays on reserve deposits to domestic banks
- Quantitative easing (QE)-The BoE has also provided economic stimulus through asset purchases, a policy known as quantitative easing (QE).
- The BoE’s Monetary Policy Committee (MPC) pursues its primary mandate of price stability by targeting an annual inflation rate determined by the government to be most consistent with that objective.
- The Monetary Policy Committee (MPC) decides what monetary policy action to take. The MPC sets and announces policy eight times a year (roughly once every six weeks).
Impact of rise in interest rate on bonds:-Bond yields are significantly affected by monetary policy—specifically, the course of interest rates.
- A bond’s yield is based on the bond’s coupon payments divided by its market price; as bond prices increase, bond yields fall.
- Example-Let’s say you have a $1,000 bond that has an annual coupon payment of $100, and it’s selling near par, for $1,010. Its yield is 9.9% ($100 / 1010). Now, let’s say the bond’s price jumps to $1,210. Its yield falls to 8.3% (100 / 1210).
- Falling interest rates make bond prices rise and bond yields fall. Conversely, rising interest rates cause bond prices to fall, and bond yields to rise.
Example- When the risk-free rate of return rises, money moves from financial assets to the safety of guaranteed returns i.e., if the interest rate rises from 2% to 4%, a bond yielding 5% would become less attractive. The extra yield would not be worth taking on the risk. Demand for the bond would decline given supply. Thus, bond price falls and the yield would rise until supply and demand reached a new equilibrium.