Factors That MPC Needs To Consider Before Making Interest Rates Decision

This is an extremely popular question tested by Edexcel. It has appeared in the following years:
(i) June 04, Q1 (b) (iii)
(ii) June 05, Q2 (a) (iv)
(iii) June 06, Q2 (b) (ii)
(iv) Jan 07, Q1 (c)
(v) June 07, Q1 (b) (ii)
(vi) June 08, Q2 (b) (iii)

Indicators that are of interest to the MPC (Monetary Policy Committee) before any interest rate decision: (one at a time, ceteris paribus)

(1) Sub prime mortgage crisis. The imminent housing market crisis which originally stems from ‘generous lending’ has now caused a collapsed of households’ wealth. Consumer spending which forms the largest bulk of UK's GDP will be severly affected. AD will fall & there will be a downward pressure on price level. To meet the the inflation target, normal stance would be to slash interest rates

(2) Unemployment. If unemployment is rising, it could be a sign that the UK economy is slowing down or perhaps hit by a recession. In such period, people are less willing to spend & price level will likely fall. Therefore MPC may choose to slash interest rates

(3) Savings. High level of savings translates to lower spending in the economy & therefore price level is likely to be low. MPC may opt to maintain or slash interest rates

(4) Change of retail sales. If retail sales are growing at a healthy rate, this means high level of household spending into the economy. As consumption is the largest component of AD & standing of about 66% of UK’s GDP, this will most likely trigger inflationary pressure. To dampen the effect, MPC will choose to increase interest rates

(5) Exogenous shocks e.g. high oil price. UK is now a net importer of oil. As such this could lead to period of cost-push inflation. To reduce the pressure of inflation, MPC may choose to raise interest rates

(6) Fiscal stance. MPC has to factor in the current level of government spending, personal income tax, National Insurance Contributions (NIC), tax allowance, corporation tax etc. If say, level of taxation is low, it could be an indicator that consumption spending is on the upward trend & inflationary pressure is riding up. Therefore, MPC will most likely increase interest rates

(7) Level of confidence in the economy. This can be accrued to many factors such as performance of stock market, extent of job losses & threat of terrorism, not just the performance housing market (although arguably it is the main driver). Under the period of pessimism, inflationary pressure is unlikely to build up. Therefore MPC may choose to maintain or slash interest rates

(8) Exchange rate. If pound is weakening, this could likely trigger an increase in price level. Falling pound means other countries such as US, France, Germany & Italy will find that it is relatively cheap to buy from UK & therefore this will boost the export market. Meanwhile in home country, Britons will be discouraged to consume imported goods given the fall in purchasing power. The net effect would be an increase in net exports. Therefore MPC will likely to raise interest rates

In reality, there is no ceteris-paribus. More often than not, interest rate changes can improve one thing but at the expense of another. We called it as trade-off. For e.g. raising interest rates to curb inflation at the same time may dampen UK economic growth & thus creating more unemployment