How we make the sums add up - by the Bank

The Bank of England today provides the first real insight into the thinking behind its interest-rate decisions with details of how monetary policy affects growth and inflation.

Unveiling some of the secrets of its complex models of the British economy which has been much in evidence over the last 18 months, the bank reveals that changes in borrowing costs start to affect growth almost immediately, but take a year to have an impact on inflation. While stressing that its models provide simulations rather than forecasts, today's report illustrates the raw material considered by the nine members of the monetary policy committee when they meet each month to set interest rates.

The models suggest that, all other things being equal, a one percentage point rise in base rates cuts gross domestic product by 0.2% to 0.35% and shaves 0.2 to 0.4 percentage points from the inflation rate.

However, the bank says that it uses the models as a tool-kit for understanding the workings of the economy, with the mpc using other sources of information and its collective judgement before coming to a decision on rates.

'The bank's use of economic models is pragmatic and pluralist. In an ever-changing economy, no single model can possibly assimilate in a comprehensible way all the factors that matter for policy', the bank's governor, Eddie George, says.

In a foreword to a new book on the bank's models, he added: 'Forming judgments about those factors, and their implications for policy, is the job of the committee, not something that can be abdicated to models or even to modellers. But economic models are indispensable tools in that process.'

The report, requested by committees of the house of commons and house of lords, says that there are four key links in the transmission mechanism between the MPC's decisions and the path of growth and inflation.

First, official interest rate decisions affect market interest rates - such as mortgage rates and bank deposit rates. At the same time, policy actions and announcements affect expectations about the future course of the economy.

Second, these changes influence the spending, saving and investment decisions of individuals and firms. The bank said that, other things being equal, higher interest rates tend to encourage saving rather than spending, and lead to a higher exchange rate, which makes imports cheaper relative to goods made in Britain.

As such, interest rates affect the demand for goods and services produced here, and the level of this demand relative to the supply capacity of the economy has a key impact on domestic inflation. Finally, exchange rate movements have a direct effect on inflation through those goods and services that are imported.

The bank said that an unexpected move in official rates would have a more marked effect than one that had already been discounted. On the basis of an unexpected rise that lasts for one year, its models suggest that 'real gross domestic product starts to fall quite quickly after the initial policy change. It reaches a maximum fall of between 0.2% and 0.35% of gdp after around five quarters. From the fifth quarter onwards, gdp returns smoothly to base.

'The course of inflation, in contrast, is little changed during the first year. But in the second year, inflation falls sharply, and the maximum effect is felt after about nine quarters. In one case, the fall is about 0.2 percentage points at its largest, and in the other, it is around 0.4 percentage points. In both cases, the impact on inflation then starts to diminish, but it has not returned to base three years after the initial policy change, even though policy was reversed after one year.'