3.2.4.3 - Central banks and interest-rate policy

Central bank and policy objectives

A central bank supplies the monetary system's settlement money and pursues public policy objectives rather than operating as an ordinary retail bank.

Central-bank functions include issuing banknotes, providing accounts and settlement facilities for banks, implementing monetary policy and supporting financial stability. In a liquidity emergency it can provide lending against appropriate conditions to eligible institutions; this lender-of-last-resort role does not mean every insolvent bank is guaranteed rescue. The Bank of England also has regulatory and resolution responsibilities considered in the financial stability lesson. It does not normally provide households' current accounts or decide every mortgage rate.

It also acts as the government's banker through wholesale banking services, including payment, custody and settlement facilities. Providing those services does not mean choosing the government's taxes or expenditure. The distinction separates monetary institutions from fiscal decisions. Source: Bank of England, Banking services, checked 1 October 2026.

Monetary policy influences interest rates, money and credit conditions, and through these the exchange rate and aggregate demand. The government sets the objectives; the Monetary Policy Committee (MPC) makes operational monetary policy decisions to pursue them. Operational independence is not independence from the mandate or accountability.

Position verified on 1 October 2026: the Bank's May 2026 discussion of the 2025 government remit confirms a primary objective of price stability and, subject to that, support for government economic policy including growth and employment. The target is 2% annual CPI inflation, measured by the twelve-month increase in the Consumer Prices Index. This is a symmetric target: persistently below 2% also matters. It is not a target for zero inflation, the level of prices, or 2% real GDP growth. The framework recognises temporary deviations after shocks and trade-offs over the speed of returning inflation to target. Source: Bank of England, The MPC's remit and trade-off management, 29 May 2026.

Price stability makes contracts, saving and investment decisions easier. It does not remove every economic fluctuation. In particular, monetary policy cannot permanently raise real productive capacity merely by expanding spending faster than the economy can supply goods and services.

MPC decisions and forecasts

The MPC sets Bank Rate in light of the expected inflation outlook, rather than reacting mechanically to the latest inflation number.

Bank Rate is the Bank of England's policy interest rate, including the rate paid on eligible reserves held at the Bank. It influences market rates and banks' lending and deposit rates, although pass-through need not be immediate or complete. The MPC may raise it when demand and persistent domestic price pressures threaten above-target inflation, or cut it when weaker spending threatens inflation below target. A decision also depends on how much earlier policy changes have already affected the economy.

Relevant evidence includes current and forecast CPI inflation; wages relative to productivity; vacancies, unemployment and labour shortages; consumption and investment; spare capacity; credit conditions; inflation expectations; sterling; and global commodity prices, demand and other central banks' policy. Wage growth alone does not establish an inflation problem if productivity grows correspondingly. Low output growth alone does not establish spare capacity if supply growth has also weakened. These are competing interpretations requiring evidence.

Time lags make policy forward-looking. A fixed-rate mortgage holder may not face a rate rise until refinancing. A firm's investment project may take months to cancel or complete. Data can be revised and future shocks are uncertain. The MPC therefore weighs forecasts, risks and the costs of moving too quickly or too slowly, rather than promising an exact inflation outcome on a fixed date.

A real, dated example illustrates this. On 6 February 2025, the MPC cut Bank Rate to 4.5%. Its report described weaker demand alongside slower supply growth, and expected an energy-related near-term inflation pickup. The decision therefore did not mean every inflationary pressure had disappeared. It reflected a judgement about persistent pressures and the outlook. The report also identified uncertainty from international trade policy and euro-area developments, which affect UK exports, confidence and imported costs. These are February 2025 assessments, not claims about today's rate or realised later outcomes. Source: Bank of England, February 2025 Monetary Policy Report.

Domestic interest-rate transmission

A policy-rate change affects inflation through decisions by households, firms and financial institutions.

For a rate rise, follow a possible chain:

1. Banks raise some lending and deposit rates as funding and opportunity costs change.
2. Borrowing for consumption or investment becomes more expensive, and saving becomes more attractive relative to spending now.
3. Variable-rate borrowers have less disposable cash after debt payments; fewer investment projects offer returns above their financing costs.
4. Consumption and investment fall relative to what they would otherwise have been, reducing aggregate demand.
5. With weaker demand pressure, firms find price rises harder to sustain; output and employment may also weaken in the short run.

Lower asset prices can reinforce this effect: higher required returns reduce the present value of future income, potentially lowering bond, share or property prices and the wealth or collateral available to support spending. Expectations matter too. Credible action can reduce expected inflation, influencing wage negotiations and price setting.