Tuesday, September 15, 2009

Bank of England's Interest Rate Decisions

The Bank of England have responsibility for setting interest rates. There is a brief overview of how they set interest rates here.

Since the Bank of England was made independent, in theory, there is greater transparency with the Bank of England publishing the minutes of minutes into deciding interest rates.

But, behind the closed doors, recent revelations suggest it is not just a polite gentleman's club. According to David Blanchflower, a former member of the MPC, a divisive battle was played out before the Bank's dramatic decision to cut interest rates by 1.5% in November. (see: New Statesman)

David Blanchflower was critical of the Banks model of deciding interest rates and predicting the state of the economy. He argues the Bank relied too much on theoretical models which came to place an unwarranted emphasis on the risks of inflation and underestimated the growing evidence of recession and financial crisis.
"I focused on the
empirical data suggesting Britain was heading for recession; Mervyn and the rest of the committee focused on their theoretical models and the (invisible) threat of inflation. In fact, the Bank of England may more suitably be called "the Bank of Economic Theory". Unfortunately, the economic theories failed just when we needed them most."
Eventually, David Blanchflower had his way and the Bank cut interest rates dramatically. However, he argues that if the Bank had cut interest rates earlier, the impact of the recession may have lessened.

It highlights another example of the limitation of relying on economic theory and models. see: Failure of economics.

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