Setting Britain's interest rates

Who decides interest rates?

The Bank of England's monetary policy committee meets on a monthly basis to set UK interest rates, after the chancellor, Gordon Brown, handed over day-to-day control of monetary policy to the Bank five days after Labour's election victory. It was the probably the biggest monetary policy change for more than fifty years: the Bank of England Act 1998 replaced the 1946 Bank of England Act.

There are nine members of the MPC. Five are from the bank of England, including the governor, Eddie George and deputy governor Mervyn King. The chancellor appoints four others, who serve fixed terms of two or three years. These currently number two academics and two full-time committee members: Cambridge university professor Willem Buiter, professor Charles Goodhart, Dr DeAnne Julius and Dr Sushil Wadhwani.

What happens if the MPC disagree?

The MPC takes its decisions on a majority vote, with the governor holding the deciding vote if the committee is split. How each member votes is recorded in the meeting minutes, which are published a week after the decision is announced.

There have been significant rows in the past. Last autumn, the four independent committee members were refused research resources they requested from the deputy governor. Some of the independent members argued that higher productivity was easing long-term inflation pressures, but felt they had insufficient resources to support their case.

The Bank of England backed down, and Eddie George announced each outside member would in future have two economists assigned to them to assist with their research. The MPC also now discusses the work of the Bank's economics team and set its priorities when they release their quarterly inflation report.

Does the government get involved?

Before Mr Brown's decision, setting interest rates was the responsibility of governments.

The government invariably influences the committee in several ways. The MPC is formally charged with delivering price stability. After its foundation, the government instructed it to help maintain its inflation target of 2.5%. It also must "support the government's economic policy, including its objectives for growth and employment."

Members of the Treasury can attend meetings but they are not allowed to vote on the committee's decisions.

There is always speculation about how much influence the government tries to wield over the committee. The Treasury sometimes publicly signals the decisions it wants taking. At the end of January Gordon Brown made a statement on monetary policy at the monthly meeting of European Union finance ministers in Brussels, in which he hinted that rates could rise to head off the threat of inflation.

Michael Portillo recently reversed the Tories' opposition to an independent central bank. He promises that the Conservatives would go further than the government and establish more clearly the independence of the committee's members. Mr Portillo wants to establish a parliamentary committee dedicated to scrutinising the MPC (it is currently done by the Treasury select committee), increasingly accountability and holding the power to scrutinise and confirm committee appointments.

Why did Gordon Brown give up his own power to set rates?

Many observers were amazed that, after an 18-year battle to get its hands on the levers of economic power, Labour threw away the most important one within days of coming to government.

But as Labour pledged in its manifesto, it desired economic stability, creating the correct conditions for economic growth, above all else. Taking the politics out of deciding interest rates could help avert a future cycle of boom-and-bust.

Politicians are wedded to electoral cycles and getting re-elected. Often political needs clash with the best interests of the economy. A government may want to stoke the feelgood factor or wow voters with generously low mortgage rates just before an election, when the economy requires a healthy dose of deflation.

The disastrous aftermath of Black Wednesday, when Norman Lamont was humiliatingly forced to withdraw from the ERM in 1992, and the 1980s boom, stoked by Chancellor Nigel Lawson's inflationary policies, added to the impression that politicians were not to be trusted with interest rate decisions.

What do critics of the Bank argue?

There is an economic argument and a political argument against the existence of the MPC. The economic critique offered by the centre-left over the last two and a half years asserts that the Bank's hawkish, conservative concern to keep inflation down at all costs has made it too ready to increase interest rates.

The inequalities in Britain's economy have been heightened, critics argue, by the Bank's decisions. Recent interest rate rises have aimed to stop the economy and housing market overheating in the south east. But in the north, the economy is less prosperous and companies need low interest rates to encourage them to borrow and invest in their businesses.

Raising interest rates also keeps the pound strong. A high pound, making British exports expensive abroad, has continued to decimate the country's manufacturing base, something which Labour pledged it would put a stop to.

The political argument against the committee suggests that unelected officials should not be in charge of interest rate policy. As shadow chancellor Michael Portillo's proposed reforms indicate, some believe there is a lack of democratic scrutiny and control of the committee.

While part of the Treasury committee's role is to scrutinise the MPC, the US central bank, the Federal Reserve, which sets US interest rates, is watched over by two powerful banking committees, one for the House of Representatives, the other for the Senate. The House committee has 50 members, a support staff of 65, and a ?4.8 million budget.