Over last two decades, the Bank of England has shifted from focusing
on money supply to using interest rates as its primary monetary
instrument. Discuss the relevance and merits of this shift in policy.

Actually it is inflation targets.

The actual means they use are probably subliminal.

It's true they do send messages "subliminally" to make things happen,
but the UK does in fact manipulate interest rates to get things done.

Their main goals (much like most other developed nations) are 
1) Keep a fairly steady inflation rate (2% is the stated goal in the
UK, whereas 2.5% seems to be the goal in the US)
2) Keep a steady growth in the overall economy

As you stated, they are currently focussing mostly on interest rates
to achieve these goals.  Interest rates mainly affect the demand for
money.  As interest rates rise, individuals and businesses have
incentives to borrow less money while saving more.

Your question about why use interest rates instead of money supply is
more of a simple preferrence.  It seems that most developed countries
in recent decades have turned to influencing interest rates moreso
than money supply.
I think this is because money supply is no longer in the hands of
government.  Thanks to banks and other financial institutions, money
is created and multiplied.  The velocity of money is also
uncontrollable by the government and may greatly change the desired
affects of changing money supply.  These uncertainties in money supply
make it a less than ideal approach to achieving their monetary policy
goals.

Changing the demand for money using interest rates gives them more
control.  Do keep in mind however that all monetary policy takes much
time to take full affect and even using interest rates, the desired
goals are never exactly met.

I actually find the concept of markets and consumers reacting
violently to a 0.25% hike in interest rates quite funny.

Companies that are net borrowers at a floating rate should be closed down.
Sensible companies will be sitting on a cash pile. Extra interest thank you.

Of course an increase in the interest rate will affect companies'
investment decisions - but in the real world investment decisions are
not made on DCFs, they are made on 2 year payback, 5 year payback etc.
DCFs are just 'paper justifications' understood by few outside the
finance department (and in my experience by few /inside/ the finance
dept.)

Consumers borrowing on credit cards are paying interest at a rate
wildly above the Bank Rate.

People with large mortgages will get a bit hurt
- but they are just a small sector

People borrowing using secured loans are also normally paying way
above the Bank Rate

People with building society/cash deposits will actually be better off

It is hardly likely to make people save more, in the UK people are
rather unkeen on formal saving - given a choice of jam today or jam
tomorrow a very large section of the population opts for 'today'. They
aren't thick.

Some people might move out of low yielding shares and into bonds
- but mostly investors are in shares for capital gains

An increase in interest rates could pull in some hot money from
abroad, which would tend to push up the exchange rate, the movement of
which would bring in yet more hot money ...
- but that sort of capital flow tends to disappear as fast as it arrives.

If say, the UK is running consistently higher interest rates than
Europe and America one would expect some longer term capital to
arrive, probably buying bonds - but that is pushing /up/ the 'supply
of lending cash'.

As for monetary policy (trying to control the 'money' supply)
Long ago that fell foul of Goodhart's Law which is roughly:

  'Any observable relationship holds true, until it is used as a basis
for policy, at which point it breaks down.'

I suppose I should add what is really going on.

The Government is trying to scare consumers. And through them, the markets.
Nearly everyone knows that Gordon is fanatical about the inflation target

Most people know that the last time wild inflation was brought to
heel, was by brutal unemployment.

Wave the spectre of unemployment under the nose of working consumers,
and they will tend to get a bit worried.
Plant loads of stories about consumers 'staying away from the high
street' and many people in fragile jobs will do just that. Herd
instinct.

That has a real effect rippling back through the retail trade to the
few manufacturers we have left.

One can play a similar game with the lower end of the housing market,
scare off first time buyers and buy to let-ers with the prospect of
(future) huge interest bills and falling house prices (ie: instant
negative equity) and the effect ripples up to the middle end where
people have been gloating over their 'property values'.

Basically we are seeing an attempt at Pavlovian demand management.

I wonder whether it will work.

Frde, if what you say were correct then the raising of interest rates
by the powers that be would have the exact opposite effect of what
they desire.

According to your scenario:
They raise "interest rates" and this scares off the public from
borrowing money.  Since there is now less demand for money then real
interest rates will fall.  So in essence, by "raising interest rates"
they are actually lowering interest rates in the real world.
What you're saying is that they don't really control interest rates,
just people's perceptions of interest rates.  And I must disagree,
since real interest rates are in fact influenced (whether directly or
indirectly) by their decisions.  If their decisions only influenced
people's reactions then as I said before; they would have the exact
opposite effect of what they desire.

Ouch - I've had the odd glass, so bear with me..

>Frde, if what you say were correct then the raising of interest rates
>by the powers that be would have the exact opposite effect of what
>they desire.

>According to your scenario:
>They raise "interest rates" and this scares off the public from
>borrowing money.  

Make consumers afraid of unemployment
Make retailers scared of dropping demand
Make new/speculative house buyers wary
Make home owners (40% mortgage) uncomfortable
- the latter is interesting - that old fraud Milton Friedman got one
thing right (although he nicked it from Ando and Modigliani - also
Brumberg)

- Punters go wild when they reckon they own a gold mine.
  ( economics translation: expenditure is partially dependent on the
ratio of human to non-human wealth)

>Since there is now less demand for money then real
>interest rates will fall. 

Who is talking about money ? - I always say 'money'
- true the demand for credit is perhaps reduced ...
- and maybe total 'demand' is reduced

> So in essence, by "raising interest rates"
>they are actually lowering interest rates in the real world.

Nope - they are raising 'nominal interest rates'

>What you're saying is that they don't really control interest rates,
>just people's perceptions of interest rates.  

They control the base rate
If you are in the UK look at the plethora of 'other' interest rates

>And I must disagree,
>since real interest rates are in fact influenced (whether directly or
>indirectly) by their decisions.  

Don't use the phrase 'real interest rates' unless you are sure of the meaning
- they are: Nominal rates - Inflation 
  I reckon about : 4.75 - 3 = 1.75    (I reckon inflation is 3%)

Of course nobody borrows at bank rate...

>If their decisions only influenced
>people's reactions then as I said before; they would have the exact
>opposite effect of what they desire

As a complete digression, I used to have a slim paperback titled 'A
General Theory' by some old p**ftah called John Maynard Keynes

In it he was .. grasping at various ideas, but they were not totally joined up.

One of them was: 'The interest rate is wot the Govt says it is'
- astute

What he missed was that there are as many 'interest rates' as there
are so called 'money supplies' - but to be fair he did not know about
credit cards and in-store lending.

My view is that they are trying to scare the economy into 'less exhuberance'
- by waving a toothpick

The darndest thing is that it might work

Expectations.

But what you're saying is that the government doesn't affect interest
rates, they just wave a threatening toothpick.  But think about that
toothpick, what does it do?  What you said is "scare the economy into
'less exhuberance'".  But if this is the case then there demand for
"credit" (since you don't like money) decreases.  When the economy is
less exhuberant, people spend less and borrow less.  That would drop
interest rates because the demand for credit would be decreased and
banks would compete by lowering interest rates in order to be able to
lend out their money.

So if what you're saying is correct then when the government raises
their interest rates then all the other interest rates out there would
decrease.

That is simply not the case because other interest rates go up soon
after (or even simultaneously) with the government rate.  I know with
100% certainty that happens in the US, and if that doesn't happen in
the UK then I'd be interested in why and what messed up system they're
using :)

Check out the federal funds rate vs the 30 year mortgage rate (or any
other major interest rate) if you doubt that the US works this way:
http://research.stlouisfed.org/fred2/series/DFF/118/10yrs
http://research.stlouisfed.org/fred2/series/MORTG/114/10yrs

You can look at the data and see it is highly correlated, but if you
still doubt, run a regression I'm certain you will find that I am
correct.
If what you are saying is correct then you would expect these data
sets to be inversly correlated because as the FED raises the federal
funds rate all it would do is scare the public into not spending as
much (borrowing less) which would lower other interest rates, but that
is clearly not the case.

@Jack

>But what you're saying is that the government doesn't affect interest
>rates, they just wave a threatening toothpick.  But think about that
>toothpick, what does it do?  What you said is "scare the economy into
>'less exhuberance'".  

Yes - you win the Green and Brown tartan - that Spans ...

>But if this is the case then there demand for
>"credit" (since you don't like money) decreases.  

Because you scare the b*ggers

>When the economy is
>less exhuberant, people spend less and borrow less.  That would drop
>interest rates because the demand for credit would be decreased and
>banks would compete by lowering interest rates in order to be able to
>lend out their money.

Nope 
- The base rate is set in iron
- The banks lend at B + U + R    ( Base + Usuary + Risk )
  If R goes up the flock panics

Consumer lending is fairly capital intensive.

I'm not sure where you got the formula:  bank interest rate = B + U + R

Bank interest rate is based on supply and demand.  If they have more
money available than they can lend out then they are losing money (by
not earning interest) on that extra money so they will lower their
interest rates to lend out that money.  Likewise, if they could be
lending out more money than they are but simply don't have that money
to lend out then they will raise interest rates to get more interest
out of the money they do lend out.
Risk is taken into account, but only as far as individual risk... as
in; they charge a higher interest rate to an individual with a bad
credit history because he is less likely to repay the debt.

I think this might be our whole disconnect.  You are basing your
assumptions on a fairly fixed rate economy where I'm basing my
assumptions on the real world (atleast in the United States) which is
a market economy.  Perhaps the UK differes from the US in the way the
banks determine their interest rates?

>I'm not sure where you got the formula:  bank interest rate = B + U + R

From observation.

>Bank interest rate is based on supply and demand.  If they have more
>money available than they can lend out then they are losing money (by
>not earning interest) on that extra money so they will lower their
>interest rates to lend out that money.  

Nope - banks can get hold of a virtually unlimitted supply of 'cash'.
If, in the unlikely circumstances, they find themselves with a
surplus, they can lay it off elsewhere.

Their problem is getting hold of good quality borrowers.
ie: borrowers that they can stiff, but who will not default

That goes for lending to domestic clients, small companies and large companies.

>Likewise, if they could be
>lending out more money than they are but simply don't have that money
>to lend out then they will raise interest rates to get more interest
>out of the money they do lend out.

As I said before, they can get hold of a virtually unlimited supply of 'cash'
There are of course 'prudence' levels, once called reserves, but it is
pretty easy to jigger those.

>Risk is taken into account, but only as far as individual risk... as
>in; they charge a higher interest rate to an individual with a bad
>credit history because he is less likely to repay the debt.

Perhaps, but since they generally ensure that any debt is well
secured, the real 'risk' is having to recover the debt.

I would say that they charge what the market will bear, but they don't
lend if they are not pretty sure that they will get their money back.

>I think this might be our whole disconnect.  You are basing your
>assumptions on a fairly fixed rate economy where I'm basing my
>assumptions on the real world (atleast in the United States) which is
>a market economy.  Perhaps the UK differes from the US in the way the
>banks determine their interest rates?

To some extent you are right there, the British banking setup is
slightly different from that of the US.

In the 1970's we saw a lot of US commercial lenders moving into London
because our rules were less restrictive than those of the US.
This led to a lending frenzy, with the inevitable results.
(However we managed to create our own frenzy in the early 1970's, when
banking rules were 'revised' by that idiot Edward Heath, so we could
have managed the second frenzy without outside assistance)

Throughout the late 1980's our rules were tightened up, although I'm
uncertain how strict they really are. Mostly it is a matter of lip
service and employing Compliance Officers as professional internal
pests and fall guys.

In the last few years we have seen US lenders targeting UK consumers,
offering amazingly low rates on plastic ( a mere 12% - 15% ) compared
with the then prevailing rates of 20% - 30%.

For some reason the UK population tends to borrow significantly less
than those in the US, partly because our property prices mean that
most seriously vulnerable borrowers are up to their ears in mortgage
debt.

By the time they have got through that baptism of fire, good risk
borrowers tend to be a bit more cautious. Sure they borrow, but
largely against their increase in property values.

Of course there are plenty of potential borrowers out there, but
because they have no assets, they are pretty high risk.

One of my favourite snippets is a major car sales company that sells
used cars, but they only do that to sell the credit.
A bit like opening up house building company, but only to sell the mortgages.

The history of British banks follows a general pattern which is,
incautious lending to property, commercial and overseas borrowers
leading to a crisis from which they recover by milking the domestic
(household) and commercial market.

However, it is ironic that a UK Bank has bought the US Household
lending company, that specializes in lending to dodgy customers in the
US.