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LISTEN TO THIS ARTICLE:In charge of setting the monetary policy for the British pound (GBP), among other things, the Bank of England (BOE) is one of the oldest central banks in the world. It currently plays a pivotal role in the world’s central banking as an active member of international joint monetary policy actions.
Many of the BOE’s actions may appear conservative, like the British nation. But behind appearances, this is one central bank that has written history – it has survived wars, the gold standard, the replacement of the GBP as the world’s international currency, and so on.
Today, the BOE is one of the most respected central banks in the world. With its headquarters in the world-famous City of London, the BOE performs many other tasks besides setting monetary policy for the GBP.
This article aims at revealing the job the BOE does and its role in one of the world’s largest economies. Moreover, the article will focus on what a currency trader should monitor when it comes to the BOE’s actions.
The GBP pairs section of the Forex dashboard contains some of the most volatile currency pairs. The GBPCHF and GBPJPY, for instance, have an Average True Range (ATR) much bigger than most of the other pairs. For this reason, many traders prefer GBP pairs when trading strategies meant to rip the most pip points in a market move.
Recent events challenged the BOE to the extreme – Brexit, Brexit negotiations, the coronavirus outbreak. As with any central bank, the BOE’s role is often invisible to market participants during normal times. However, when things get tougher, the BOE is one of the leading institutions in the United Kingdom, trusted by the population to show the path forward.
Bank of England – Generalities
Not everyone is aware of it, but the BOE is a public institution that answers to the United Kingdom’s Parliament. The BOE’s Governor and other representatives are often required to appear in front of the House of Commons Treasury Committee to explain the decisions taken by the BOE.
Just before the year 2000, the BOE was granted independence in some areas so as not to be swayed by political influences. Today, the bank stands as a model of central banking independence for similar institutions around the world.
The good of the people is part of the BOE’s mission. To achieve that, the bank focuses on monetary and financial stability via, for example, ensuring that the population can rely on payment services.
The bank is run by a Court of Directors acting in a similar way to the Fed’s Board in the United States. It consists of the Governor, four deputy governors, and seven non-executive directors appointed by the government.
One of the most-watched market events is the Monetary Policy Committee (MPC) outcome. Few traders are aware that, besides the MPC, the Financial Policy Committee and the Prudential Regulation Committee also belong to the BOE. All three committees are chaired by the BOE’s Governor.
Until recently, the BOE was the first major central bank to be run by a non-British Governor – Mark Carney. A former Governor for the Bank of Canada, Carney served the BOE as Governor during one of the most difficult times in the history of the bank – the Brexit referendum and its outcome. Currently, the BOE is run by Andrew Bailey, who is acting as its chief executive.
Bank of England – History
With a history of over three hundred years, the BOE first started operating as a private bank. Its mission was to fund the government in its effort to win the war with France at the end of the 1600s.
It issued the first denominated banknotes in 1725, and in 1797 it suffered a “bank rush,” the first serious crisis. France threatened war, and the news spread quickly. People lined up at the BOE’s door to convert their banknotes into gold, depleting the gold reserves, until an order from the Privy Council forbade the BOE to pay notes in gold any longer.
In 1914, the BOE played a crucial role in funding World War One. It issued war stocks and ended up buying them from its own reserves, basically funding the government and hiding the fact from the general public.
Montagu Norman was, perhaps, the most iconic figure at the helm of the BOE. He ran the bank for twenty-four years and was a key figure in establishing the Bank for International Settlements (BIS). His vision and the relations established with fellow central bankers from the United States, France, and even Germany, helped him in making the best fiscal and monetary policy decisions at the time.
In 1946, the BOE was finally nationalized. Despite working for the government for all this time, it was still in private hands. After 1946, the government started to appoint governors and directors.
Perhaps the most famous event involving the BOE was the United Kingdom’s crash out of the European Exchange Rate Mechanism (ERM) in 1992, only two years after joining it. George Soros remains in history as the man who broke the BOE, as he and his investment fund made billions by betting against the GBP, and, literally, against the BOE.
Monetary Policy
One of the major roles of the BOE is to set the monetary policy in the United Kingdom. Effectively, this refers to actions taken by the bank to influence the supply of money in the economy (thus, inflation) and interest rate levels (cost of borrowing).
At first glance, it sounds like a simple task. However, balancing the two in a way that stimulates economic growth is a tough job with plenty of hurdles.
Besides deciding on the interest rate level, the BOE also creates digital money to buy bonds. The process, called Quantitative Easing (QE), was first introduced in the United States by the former Fed Chair Ben Bernanke.
During the Great Financial Crisis of 2008, the United States Federal Reserve slashed the federal funds rate to almost zero. In a desperate attempt to calm the markets, it began buying government bonds directly in various stages with money created by the Federal Reserve. The method was quickly embraced by other major central banks around the world, and today it is a popular monetary policy tool in many jurisdictions.
Through QE, the BOE injects money directly into the British economy, if needed. QE encourages spending by making it cheaper for households and businesses to borrow money, as a result of the lower interest rates offered on loans.
Therefore, the monetary policy actions the BOE undertakes refer to its decisions regarding the interest rate level and the size of the QE program, if any. Naturally, in periods of economic growth, the interest rate is on the rise and there’s no need for a QE program. The opposite is true during bleak economic periods.
The BOE’s Mandate
Like any central bank, the BOE has a mandate. In the developed world, it has been agreed that stable prices or price stability is essential to economic growth. Moreover, price stability is linked to a certain inflation level.
To the surprise of many, this is not the zero level. Because inflation is volatile, it often deviates from the target. Therefore, if the price stability level were set to zero, for many periods of time, inflation would actually be negative, or below zero. This is called deflation, and it is much more difficult to fight with standard monetary policy tools than inflation or disinflation.
For this reason, moderate inflation is part of every central bank’s mandate. The consensus among central banks in the developed world established 2% as the threshold for inflation. More precisely, levels below but close to 2% are in line with price stability and inflation targeting.
Depending on the economic stance at any one point in time, central banks may decide to alter the inflation definition, in the sense that some banks include in the mandate a symmetrical approach to the target. Namely, if inflation deviates from the 2% target to either the upside or the downside, the symmetrical approach requires a similar distance as a threshold for the central bank’s intervention.
The BOE’s mandate to maintain price stability and confidence in the currency is strongly linked to the 2% inflation targeting. Lower inflation below 2% triggers interest rate cuts from the BOE. Conversely, higher inflation leads to higher interest rates.
Monetary Policy Committee
Every six weeks or eight times a year, the Monetary Policy Committee (MPC) decides on the monetary policy actions to take. The decision comes at the end of an entire week of analyzing the economic situation, a process often viewed as sluggish in comparison with other central banks in the world.
The MPC announces the interest rate decision on a Thursday, but the actual process starts one week earlier.
Even before that, the MPC members are briefed on the economy by the BOE staff. The BOE’s network of agents plays a crucial role in this briefing.
Many traders think of the MPC as a similar version of the FOMC in the United States. However, striking differences between the two entities exist.
The MPC announcement is often priced in by the market. At the time the bank’s decision hits the wires, traders have already positioned themselves for the implications. The same is true for the FOMC Statement, but with a big difference – every two meetings, a press conference follows the FOCM meeting. This is not the case with the MPC, where a press conference follows only if the BOE decides to change the interest rate level.
BOE Agents
The BOE set twelve agencies across the United Kingdom, and each agency has four agents. They act as the eyes and ears of the BOE in the territory, much like the national banks in the Eurozone or the Fed’s regional banks in the United States. However, the big difference is that these agencies are far smaller in size, consume fewer resources, and have a direct relationship with local businesses so that the information gathered is first-hand.
Small administrative teams support each agency, and they all compile economic reports and run research projects to present to the MPC before every meeting. These projects range from local events where people share their views and opinions about the current economic struggles, to one-on-one conversations with local business leaders, and so on. In other words, agencies gather a ton of information about all the economic sectors in a region, compile reports and deliver them to the MPC one week before the actual MPC decision.
Therefore, the MPC decision comes at the end of an elaborate process of analyzing the latest changes in the United Kingdom’s economy. Traders only find out every six weeks, on a Thursday, that the MPC cut, hiked, or held the interest rate steady, but the decision comes at the end of a week-long decision-making process.
What’s interesting is that the agencies make their findings public. Four times a year, the agents’ reports are made public, so anyone with an interest in interpreting the various details of the United Kingdom’s economic activity can do so.
The First and Second Meetings
One week before the actual MPC decision (i.e. one Thursday earlier), the first meeting takes place. During this meeting, the members discuss the economic data and confront various reports from the agencies.
A second meeting follows the next Monday. During this meeting, the focus shifts from the economic situation to the monetary policy. Members actively debate what the appropriate monetary policy decision would be and why.
The Final Meeting
Despite what the name suggests, this meeting doesn’t take place on the day of the announcement, but one day earlier. On the Wednesday before the MPC announcement, the BOE Governor recommends the policy supported by the majority of MPC members.
Each member has a vote and the MPC reflects the votes of each individual, rather than the consensus (as with the ECB). If there’s a tie, the Governor casts the deciding vote.
The MPC Announcement
The announcement is scheduled for the next day at 12:00 local time. The MPC decision is made public together with the minutes of the meetings. Spot the difference between the FOMC in the United States and the MPC in the United Kingdom – in the United States, the minutes are released three weeks after the FOMC Statement, while in the United Kingdom, they are released on the same day.
Often, the MPC minutes have a larger impact on the GBP than the actual decision. This is explained by the fact that the MPC decision is not followed by a press conference unless the BOE changes the interest rate.
In periods where the interest rate remains stable for a long time, there’s literally no communication from the BOE other than the fact that the interest rates were kept stable. Therefore, traders and other market participants focus on other elements that may offer a clue about what the MPC members think and what the medium and longer-term outlook for the UK economy and the British Pound is.
The MPC minutes reveal the vote taken before the decision, and shifts in that vote cause large fluctuations in the GBP pairs. For instance, let’s assume that at the last MPC meeting the vote was 4-1-4.
The first number shows how many members voted to increase the interest rate, the middle one how many voted to decrease it, and the third shows how many voted to keep the interest rate on hold.
If the current MPC decision reveals no change in the interest rate level with 3-2-4, the news will create a sharp reaction to the downside on the GBP. The vote shows that one previous hawkish member turned dovish, and that’s bearish for the GBP as traders interpret it as a sign for future easy monetary policy.
Financial Policy and Prudential Regulation Committees
Another important role played by the BOE is to make sure that the financial system in the United Kingdom is safe and sound. This means that it has an active role in providing a secure way to make and receive payments.
Semiannually, the BOE publishes the so-called “Financial Stability Report” compiled by the Financial Policy Committee. Interestingly, not all members of the Financial Policy Committee are members of the BOE. For instance, some are business people or academics. What the BOE intends with the membership of the Financial Stability Report is to create a mix between internal and external members, with different views and experience.
The Financial Policy Committee is relatively new. It came into existence in 2011 as the British Parliament’s response to the 2008 Great Financial Crisis. The decisions taken at the two meetings during the year set the directions that the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) must follow.
For traders, the FCA is of particular importance. It is the de facto regulator for providers of financial services in the United Kingdom. Effectively, no Forex broker or other financial services provider can offer its services to the British people without being regulated by the FCA.
The conditions imposed by the FCA refer to various aspects of how to run a business. For instance, after obtaining a license from the FCA, a brokerage house must maintain certain standards and constantly report to the FCA.
Emergency Rate Cuts
Every now and then, a central bank finds itself “cornered” by sudden events in the market. As such, it must react on the spot, without waiting for the regular meeting at the end of every six weeks.
Emergency rate cuts happen when, in between meetings, the central bank decides to cut the interest rate level. The United States Fed and the BOE have used emergency rate cuts many times in the past. One good question here would be – why are there no emergency rate hikes?
Modern economic theory argues that when things go wrong, or when the economy suddenly outperforms, the speed of the economic deterioration is much higher than in times of economic expansion. Economic contraction has always been met with rate cuts, so the central banks simply deliver the known medicine as soon as possible, without waiting for the regular meeting. A good comparison is a sick person who goes to the doctor as soon as possible to be treated and get well.
In times of economic growth, the situation differs. When the economy grows too quickly, it is said that it is overheating, and the risk of inflation spiraling out of control is real. However, there is no need for the central bank to intervene between two meetings, as the sense of urgency is not perceived as similar to situations of economic recession.
Central banks typically intervene during economic recessions. Or, more precisely, they intervene when conditions deteriorate so much that they signal imminent recession.
The 2008 financial crisis was one example, the 2020 coronavirus another. One after another, central banks around the world followed the Fed’s example and slashed interest rates to almost zero. Moreover, they did that without waiting for the next scheduled meeting but delivered the cuts as soon as possible.
Inflation Report
One of the most interesting things about the BOE is that it doesn’t hold a press conference after each meeting. In fact, only if it alters the interest rate level is there a press conference to explain the decision.
For this reason, in periods when the central bank holds the interest rate steady for a long time, market participants may be confused as to what the MPC members really think. As such, the BOE uses other communication tools to address potential uncertainty. One of these is the Inflation Report.
The chart above shows the interest rate in the United Kingdom for the last decade or so. Between 2009 and 2017, the BOE held the interest rate steady, meaning that it didn’t change it to either the upside or the downside. As such, investors often needed more details about how the central bank perceived the economic activity and economic performance, considering that there was no press conference where financial press representatives could ask questions. The inflation report solved this issue.
There is one more thing to mention here that is valid for all central banks, not just the BOE. Inflation targeting is part of the BOE’s mandate, but it doesn’t mean its role ends with it. A central bank of the BOE’s size and importance for the world’s financial system has multiple other roles, ranging from local regulation to worldwide participation in common actions with other central banks.
The Quarterly Inflation Report
Because the Inflation Report had become more than just a report about inflation, the BOE decided to change its name. As such, in November 2019, the former Inflation Report, released quarterly, became the Monetary Policy Report (MPR).
The decision to change the name is welcomed, because the report addresses more than just inflation in the United Kingdom. It also looks at growth in the United Kingdom economy, whether or not inflation reached the BOE target of 2%, the path for future interest rates, as well as other punctual things affecting the economy. Therefore, the former Inflation Report treated more than just inflation, because press representatives asked questions about different areas of the United Kingdom’s economy too.
The new MPR report quickly became a very important piece of information for anyone interested in how the economy performs in the United Kingdom and what the BOE’s measures are. A press conference follows each MPR, giving press representatives the chance to ask questions and the market to digest the answers.
Today, the MPR is a top-tier market event, with huge implications for the GBP’s evolution. Traders have the chance to become familiar with the BOE’s view regarding the United Kingdom’s economy and to prepare accordingly.
Brexit
June 23, 2016 will remain as the date of the infamous Brexit referendum. Voters across the United Kingdom were asked whether the country should remain in the European Union or leave.
To the surprise of many, both British and from around the world, the United Kingdom voted to leave the European Union. Brexit, as it was dubbed, became a reality.
The days before and after the referendum brought tremendous volatility in the financial markets. The entire world watched what was happening in the United Kingdom and the GBP pairs were extremely volatile. During such times, the central bank’s job is to provide liquidity to the market and to make sure everything happens in an orderly manner.
In a way, it succeeded. The GBP reacted to the Brexit news by dropping from 1.50 to 1.30 in a matter of a couple of hours or less. Still, liquidity existed and traders that wanted to liquidate positions could do so, albeit at higher spreads than usual.
One night a couple of weeks or so later, during the Asian session, the GBP melted in less than five minutes. It reached as low as 1.19 and something in the first week of October the same year, a staggering three thousand pip points lower from the June referendum.
Central banks do not intervene in the market to support a currency. At least, that’s the official language, with the exception of the Swiss National Bank (SNB) which makes no secret that it constantly intervenes to stop CHF appreciation.
However, central banks can lay the groundwork for an orderly appreciation or depreciation of the currency, so that the panic doesn’t affect traders’ decisions. For sure, the BOE did a great job both before and in the aftermath of the Brexit vote.
Coronavirus Outbreak and the Bank of England’s Reaction
Globally, the coronavirus outbreak created an unprecedented negative economic impact. Economies in Europe and all over the world simply shut down.
However, people’s bills and financial obligations are still due at the end of the month. Money must come from somewhere. The world had never considered the possibility of a pandemic, and the rules of the game must change.
Central banks are on the front line in such a crisis. As usual, the United States Fed acted first – it slashed the federal funds rate to almost zero and reengaged in open-ended Quantitative Easing, which was announced in an emergency rate cut decision.
The same happened in the United Kingdom. In a similar move to the one during the 2008 Great Financial Crisis, the Bank of England announced via an emergency cut that it was slashing the interest rate to zero and engaging in Quantitative Easing as well.
This decision injects money directly into the economy in a package that will total around seven hundred billion GBP. This is the fourth round of Quantitative Easing at the BOE, after November 2009, July 2012, August 2016 and March 2020.
Without much effort, traders can spot ground-shaking events that happened on the Quantitative Easing announcement dates (e.g., August 2016 – Brexit, March 2020 – coronavirus). But the role of a central bank in times of crisis doesn’t end here.
Central banks around the world act under the umbrella of the Bank for International Settlements (BIS). The Fed announced open swap lines denominated in USD with all major central banks in the world. In an move of unprecedented size, the Fed, together with BOE and other central banks, coordinated their efforts to ease the need for the world’s reserve currency in times of crisis. In other words, the role of a central bank exceeds the setting of the local monetary policy.
Gold at the Bank of England
One of the most interesting things about the BOE has nothing to do with monetary policy. Yet, it is worth mentioning it here, because, initially, gold sat at the heart of the financial system as we know it today.
Despite gold not playing the same role as it did in the past, central banks around the world and, implicitly, governments continue to hold large quantities of it. Transactions between governments and central banks still take place, and a competition seems to exist as to which central bank or government has the biggest gold reserves.
All that gold must be stored somewhere. Vaults are located all over the world, some of them in China, some in the Swiss mountains, and some at the BOE.
One of the world’s largest gold vaults is run by the BOE and holds approximately four hundred thousand gold bars. Before jumping to conclusions about the ownership of all these gold bars, know that the BOE only owns two of them. That’s right – two. For the rest, it acts as a custodian for other central banks and commercial firms around the world. Also, it stores the UK gold reserves on behalf of the Treasury. For those that don’t know, London is the global center for gold trading. The BOE provides gold accounts to central bank customers to support financial stability, for example.
When gold held by the BOE “changes hands,” meaning that one central bank reduces its reserves and another one buys, the physical gold does not leave the premises of the vault. Only the ownership (on paper) changes.
Conclusion
One of the most prominent central banks in the world, the Bank of England, decides on the monetary policy in the United Kingdom, among other tasks. For currency traders, this is the most important aspect of the BOE’s work, as it influences the value of the local currency – the GBP.
The GBP is more volatile than other currencies on the Forex dashboard. For example, in January 2015, when the Swiss National Bank dropped the fixed exchange rate on the EURCHF pair, the financial community focused on the huge drop that resulted in the EURCHF – from 1.20 to below 0.90. However, the GBPCHF pair dropped even more, illustrating the higher volatility of the GBP pairs.
A former world reserve currency, the GBP still plays a crucial role in the world’s financial markets. It is part of many countries’ foreign reserves, and the City of London remains the global financial center, despite Brexit.
In recent years, the BOE has changed from a conservative institution to a more proactive one. In many ways, it resembles the United States Fed, as it follows the Fed’s decisions closely, despite the BOE’s proximity to the European Central Bank.
It appointed its first non-British Governor (Mark Carney), it changed the Inflation Report, it coordinates its actions with the world’s leading central banks, and it is trying to become more transparent in its operations – all of which make it a remarkable 21st century central bank.
This trading academy covers all relevant central banks in the world as their decisions have a strong impact on the value of the local currency and in the international flow of capital. Ranking them in terms of importance makes no sense. However, if ranking criteria were allowed, the BOE would sit near the top.
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