PureFX

Does The Bank of England Set Foreign Exchange Rates?

Tue 12th June 2012

By Peter Lavelle

In this post I want to answer the question: does the Bank of England set foreign exchange rates? This might be of interest if you’re planning to transfer funds abroad, and want to getting a good exchange rate, or are simply interested in British monetary policy.

In short, the Bank of England does not set the foreign exchange rates, no. Instead, the rates are determined by international market forces according to the laws of supply and demand. For instance, if the UK enjoys a period of stable and consistent economic growth, while Europe enters recession, that makes Britain a more attractive place to put funds. That means there’s more demand to buy pounds, which means in turn that people that have pounds can sell them at a higher price. Hence, the pound foreign exchange rate goes up. This is how (in a simplified form) the foreign exchange rates work.

So the Bank of England has no influence over exchange rates?

It does, because the central bank is responsible for setting the UK’s benchmark interest rate. For instance, imagine the BoE raised interest rates from 0.5% (as they are today) to 4.0% overnight. If you were investing in the UK, that would do wonders for your shares and bonds, hence making such bonds highly attractive. That would aid the pound foreign exchange rate, as the markets bought pounds to invest in the UK. In this way, though the Bank of England can’t set the foreign exchange rate, it can have a powerful influence over them.

Do you have any examples of this?

For sure. In 2008, at the tail end of the financial crash, the Bank of England cut interest rates to an all-time low of 0.5%, to reduce the cost of lending to businesses, and hence encourage growth again. But a side effect of this was to send the pound plummeting, where it lost about 25.0% against the euro, US dollar, as well as other currencies. This is beneficial in a sense: a weak pound means that foreign companies can more cheaply buy UK goods, which should drive growth. Nonetheless, it’s a good example of the Bank of England influencing the exchange rate.

If the Bank of England raises interest then, will the pound gain?

It would be very likely, yes. In addition though, you should keep in mind that any gains in the pound would be limited by what else was going on. For instance, if the UK economy remains in a bad state, that might limit the pound, as well as the possibility of a Eurozone fallout affecting Britain too. In other words, the Bank of England’s influence on foreign exchange rates can be strong, but it’s not definitive.

Get in touch

I do hope this post has been useful.

If you have an questions not answered here, or would like to find out more, don’t hesitate to contact us at foreign exchange specialist Pure FX. One of our specialist dealers would be delighted to provide an in-depth personal response to your query, free of charge.