|
The main instrument of monetary policy is the short-term interest rate. Central banks have a variety of techniques for influencing interest rates but they are all designed, in one way or another, to affect the cost of money to the banking system. In general this is done by keeping the banking system short of money and then lending the banks the money they need at an interest rate which the central bank decides. In this country such influence is exercised through the Bank of England’s daily operations in the money markets.
The Bank of England is banker to the UK banking system. Transactions between commercial banks are finally settled between accounts held at the Bank of England by banks - 22 at present - which are members of the wholesale clearing systems. These settlement banks are expected to hold positive balances on their accounts at the Bank each day. The commercial banks’ total funds are altered by transactions between themselves and the Bank, and between themselves and the Government accounts at the Bank. Transactions between banks merely redistribute funds between themselves. Payments from the private sector to the government are finally settled by a transfer of funds between the settlement banks’ accounts at the Bank and the Government’s accounts. Thus, by managing the money flows the Bank can affect the size of the settlement banks’ balances with itself.
|
A change in interest rates will affect the economy through a number of routes. First, a change in the cost of borrowing will affect spending decisions. Interest rates affect the relative attraction of spending today as against spending later, as a rise in rates will make savings more attractive and borrowing less so, and this will tend to reduce present spending, both on consumption and on investment.
|
|
|
Second, a change in rates affects the cash flow of borrowers and creditors. A rise or fall in interest rates affects the cash flow of those with floating interest rate assets or liabilities. For example, many households have floating interest rate deposits in banks and building societies. Floating interest rate debtors include households with mortgages, and companies. Fluctuations in cash flow may affect spending.
|
|
|
Third, a change in interest rates affects the value of certain assets, notably housing and stocks and shares. Such a change in wealth may influence people’s willingness to spend.
|
|
|
Fourth, a particular pressure on prices comes through the exchange rate. For example, a rise in domestic interest rates relative to those overseas will tend to result in a net inflow of capital and an appreciation of the exchange rate. A rising pound will reduce prices for imports, thus increasing competitive pressures and supplementing the downward pressure on inflation arising from weakened demand.
|
|
|
All of these influences on demand are likely to affect prices and inflation. A rise in short-term interest rates can be expected to restrain demand for UK output in the way described. That in turn is likely to put downward pressure on UK prices and the rate of inflation.
|
|
If on a particular day more funds move from the private sector to the Government’s accounts than vice versa (for example because banks’ customers are paying their taxes), then the banking system will be short of the funds needed for the settlement banks to maintain positive balances on their accounts at the Bank. If the overall movement of funds is in the other direction, then the banking system will have surplus funds. Normally the operation of the Government accounts, including money market operations, results in the settlement banks starting each day with a prospective shortage of funds.
The Bank, through its daily operations in the money market, supplies the funds which the banking system as a whole needs to achieve balance by the end of each settlement day. It is in setting the interest rate for these operations that the Bank influences the general level of interest rates across the economy. Traditionally, in these operations the Bank has bought Treasury bills, and other eligible local authority and bank bills. In addition the Bank now operates in gilt repo. A gilt repo is a sale and repurchase agreement eg ‘A’ sells gilts to ‘B’, with a legally binding agreement to repurchase equivalent gilts from ‘B’ at a pre-determined price and date. In effect gilt repo is a cash loan with the gilts used as security.
The Bank’s daily operations to relieve the shortage are conducted through a group of counterparties which can include banks, building societies and securities firms. They are invited to apply for funds either by the sale of bills or by bill or gilt repo to the Bank. Depending on the size of the expected shortage, up to four rounds of operations may be held each day. If these operations are not sufficient to relieve the liquidity shortage there is a late repo facility for settlement banks.
Interest rates in the wholesale money market will generally be closely influenced by those at which the Bank conducts its operations. The decision by the MPC on the rate of interest is announced immediately after the monthly meeting and any change will normally be reflected quickly in the money market in general, and in banks’ base rates i.e. the rates they use to calculate their customers’ rates.
In addition to their direct effects on the domestic economy, movements in interest rates influence the value of sterling in terms of other currencies. If interest rates on sterling assets rise in relation to rates on other currencies, then (other things remaining equal) money will flow into sterling and sterling’s exchange rate will rise. The exchange rate will also reflect market expectations about economic, financial and political developments here and abroad, so that a change in interest rates may not always result in a proportionate effect on the exchange rate.
The Bank can attempt to influence the exchange rate through direct market intervention, using the country’s foreign exchange reserves. When sterling is weak the Bank can enter the market and buy sterling in an attempt to halt its decline or can sell sterling if it is perceived to be too strong. Experience shows that such intervention may be helpful in resisting shortterm fluctuations provided it is in line with the underlying trend of the market. The UK’s exchange reserves used to be held solely in the Exchange Equalisation Account owned by the Treasury. This was operated by the Bank on behalf of the Government. As part of the changes introduced by the passing of the 1998 Bank of England Act, the Bank can now manage its own pool of foreign exchange reserves, separately from those managed on behalf of the Treasury. These reserves are now available for use in operations related to monetary policy, subject to limits authorised by the Bank’s Court of Directors.
The weekly tender in Treasury bills is used to help manage the money market as well as raising cash for the Government. The Public Sector Net Cash Requirement (PSNCR) is, however, funded mainly through the sale of gilt-edged securities which are long-term investments used to finance the shortfall between Government revenues and expenditure. Prior to 1 April 1998, the role of managing the Government’s debt was undertaken by the Bank of England. On this date, however, the responsibility for the management of the Government’s debt and the oversight of the gilt market passed to a new Debt Management Office (DMO) which is an executive agency of the Treasury. The DMO also provides policy advice to the Treasury on the annual gilt programme, makes decisions concerning the initiation of sales of gilts and liaises with market participants.
Reproduced by kind permission of the Bank of England
|
