The Bank's monetary operations implement the decisions made by the Monetary Policy Committee (MPC). Since March 2009, when Quantitative Easing was initiated, this has involved both keeping short-term market rates stable and in line with Bank Rate and undertaking a targeted amount of asset purchases, which are financed by the creation of central bank reserves.
Short-term market interest rates are kept in line with Bank Rate by paying Bank Rate on all cash held in the reserves accounts at the Bank. The asset purchase target is achieved by purchasing or, in the event that the target is reduced, selling assets through the Asset Purchase Facility.
Prior to March 2009, monetary policy was solely implemented by keeping short term market rates stable and in line with Bank Rate. This was achieved through a 'reserves averaging' regime. Under this system, banks set a monthly target for their reserves balances. The Bank used its Open Market Operations to supply the correct amount of reserves to meet the banks' aggregated demand. Banks that maintained balances close, on average, to their target received interest on their balances at Bank Rate. But they were charged if their reserves balance was on average either excessively over or under their monthly target. A bank could avoid that charge by making use of the Operational Standing Facilities to meet their target.
Given the day-to-day payments between banks are to some extent unpredictable, banks had an incentive to lend to, or borrow from, each other in the inter-bank market to recycle reserves around the system so that each individual institution could meet its target. And because the banking system as a whole had the correct amount of reserves, this recycling activity tended to keep market rates close to Bank Rate.
Since the initiation of Quantitative Easing, the supply of reserves has varied in response to the MPC's policy decisions, rather than the changes in the demand for reserves. This potential imbalance in the demand and supply of reserves could have resulted in loss of control over market interest rates had banks been required to continue to set and meet targets. The Bank therefore suspended reserves averaging in March 2009. Banks are not currently required to set targets for their reserves accounts and all reserves balances are remunerated at Bank Rate. As a result there is no incentive for banks to borrow from or lend to each other at rates materially away from that, so that market rates stay close to Bank Rate.
The Bank's underlying approach to implementing monetary policy is set out in the Red Book:
The framework currently used since the initiation of Quantitative Easing is set out in Part 2 of the Red Book: