Inflation Report
Conditioning Path for Interest Rates
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Conditioning path for market interest rates
The projections for CPI inflation and GDP growth published in the Inflation Report are conditioned on a benchmark path for Bank Rate implied by certain financial market instruments. The MPC may change the way it estimates the conditioning path from time to time, since shifting market conditions can alter the relative advantages of using different methods, but the source used is always clearly stated in each Inflation Report. This page explains how the MPC has derived the conditioning path for market interest rates used in recent Inflation Reports.
From November 2004 to August 2007, the conditioning path was derived from overnight forward rates from the 'commercial bank liability curve' (BLC) *. The MPC has typically chosen to average these forward rates over the 15 days up to and including the data cut-off for the Inflation Report **. The BLC is estimated from instruments that settle on the London interbank offered rate (Libor): interbank loans; short-term interest rate futures contracts; Forward Rate Agreements and interest rate swaps.***
Since Libor rates contain a premium to compensate investors for the risk of commercial bank default, an adjustment has been applied to the BLC to account for credit risk premia when it has been used as the basis of the conditioning path for Bank Rate. This adjustment has been based on recent historical spreads between Libor rates and those on collateralised interbank loans (General Collateral (GC) repo rates). It has varied with maturity up to the twelve-month horizon, after which it has been held constant. A further adjustment has been applied to account for the recent average spread of the overnight GC repo rate relative to Bank Rate; this second adjustment has been held constant across all horizons.
A different technique was used to derive a conditioning path for the November 2007 and February 2008 Reports. Between August 2007 and February 2008, there was considerable disruption in international money markets. As a result, the MPC judged that its usual credit adjustment to the BLC was not appropriate, given the rise in credit and liquidity premia in short-maturity Libor rates.**** At maturities up to one year, the conditioning path was therefore based on an overnight forward curve derived from GC repo rates, adjusted to account for the typical spread between the overnight GC repo rate and Bank Rate. At maturities longer than 18 months, it was based on the credit-adjusted BLC that had been used to condition previous projections. These two curves were interpolated and smoothed using a curve-fitting technique.
The spreadsheet below contains the market profiles used to condition the published projections since the November 2004 Inflation Report.
Market profiles (24k)
* A curve estimated from government bonds was used as the basis of the conditioning path in Inflation Reports prior to November 2004.
** A five-day averaging window was used for the August 2007 Report.
*** Further details on how the BLC is estimated are available from the Bank's yield curves webpage.
**** Further details are provided in the Box on page 12 of the November 2007 Report.
