Quarterly Bulletin
Interest Rates Articles

Public attitudes to inflation and interest rates (768k)
By James Benford of the Bank's Monetary Assessment and Strategy Division and Ronnie Driver of the Bank's Inflation Report and Bulletin Division.
A key upside risk to the medium-term outlook for inflation stems from the possibility that a further period of above-target inflation could lead to persistently elevated inflation expectations. According to the Bank/GfK NOP survey, households' expectations for inflation over the next year have risen markedly. This article focuses on the factors which may have driven the increase, drawing on the results of some additional questions included in the February 2008 survey. It concludes that while the latest increases in households' inflation expectations could be consistent with recent macroeconomic data, increases in households' perceptions of current inflation may also have played some role. The article also summarises the public's attitudes to interest rates and the conduct of monetary policy.

Recent advances in extracting policy-relevant information from market interest rates (3.6mb)
By Michael Joyce, Steffen Sorensen and Olaf Weeken of the Bank's Monetary Instruments and Markets Division.
Market interest rates form an important part of the transmission mechanism of monetary policy. They also contain information about market expectations of future policy rates as well as attitudes to, and perceptions of, risk. Extracting and interpreting this policy-relevant information is not straightforward, however. This article describes recent advances in this field and how they can be used to shed light on the downward trend in long-term real forward interest rates and the upward trend in long-term inflation forward rates, both developments that have attracted the attention of policymakers.

Stabilising short-term interest rates (594k)
(by Seamus Mac Gorain of the Bank’s Foreign Exchange Division). This article describes how the Bank’s new arrangements for implementing the Monetary Policy Committee’s interest rate decisions should tie market interest rates more closely to the Committee’s official rate. In the new framework, banks and building societies will be able to hold an average level of reserves at the Bank over a month-long ‘maintenance period’. The article shows that the Bank’s commitment to adjusting the supply of reserves on the final day of the maintenance period should ensure that the market rate is expected to be on target on that day. It also describes how the ability of scheme members to run their reserve balances up and down from day to day in response to changes in market rates should mean that the rate expected on the final day of the maintenance period prevails over the rest of the period.

No money, no inflation—the role of money in the economy (177k)
In this article, Mervyn King, Deputy Governor, examines the apparent contradiction that the acceptance of the idea inflation is a monetary phenomenon has been accompanied by the lack of references to money in the conduct of monetary policy during its most successful period. The disappearance of money from the models used by economists is, however, more apparent than real, with official interest rates playing the leading role as the instrument of policy, with money in the wings off-stage. Nevertheless, there are real dangers in relegating money to this behind-the-scenes role.

Asset prices and inflation (108k)
(by Roger Clews of the Bank's Monetary Instruments and Markets Division). This article is one in a series on the UK monetary policy process. It discusses some of the interconnections between inflation, monetary policy and asset prices. The Monetary Policy Committee is extensively briefed on asset market developments, along with other developments in the economy, before it makes its policy decisions.

Inferring market interest rate expectations from money market rates (192k)
(by Martin Brooke of the Bank's Gilt-edged and Money Markets Division, and Neil Cooper and Cedric Scholtes of the Bank's Monetary Instruments and Markets Division). The Bank's Monetary Policy Committee (MPC) is interested in financial market participants' expectations of future interest rates. Knowledge of such expectations helps the MPC to predict whether a particular policy decision is likely to surprise market participants, and what their short-term response is likely to be to a given decision. Expectations of future levels of official rates also play a key role in determining the current stance of monetary policy. The Bank implements the MPC's monetary policy decisions by changing the level of its two-week repo rate which, in turn, influences the levels of other short-term money market interest rates. However, many agents in the economy are also affected by changes in longer-term interest rates. For instance, five-year fixed-rate mortgages are typically priced off the prevailing rates available on five-year swap contracts, and larger firms often raise finance in the capital markets by issuing long-maturity bonds. Changes in these longer-term interest rates depend to a considerable extent on expectations of future official rates. So the Bank needs to have some understanding of expectations of future policy rates, in order to monitor and assess changes in current monetary conditions.

Forward rates are the most commonly used measure of interest rate expectations. In principle, we want to derive forward rates that correspond to future two-week Bank repo rates. Unfortunately, however, there is no instrument that allows us to do this exactly. So we have to estimate forward rates from the sterling money market instruments that are actually traded.

This article argues that first, forward rates estimated from money market instruments are biased estimates of expectations of future Bank repo rates because of term, credit and liquidity premia, as well as contract specification differences. And second, no particular money market instrument is likely to provide a 'best' indication of Bank repo rate expectations at all maturities. The spreads between the Bank's two-week repo rate and the instruments used to estimate our market curves are volatile and so we cannot expect to get a result that is common across all instruments. Reflecting these considerations, the Bank estimates two forward curves: one employing GC repo and gilt data and one that uses a combination of sterling money market instruments that settle on Libor rates. A number of simple ready-reckoner adjustments can be applied to the two estimated forward curves in an attempt to transform them into an estimate of a forward curve equivalent to two-week Bank repo rates. First, the GC repo/gilt forward curve needs to be adjusted up by around 15 basis points and the bank liability curve adjusted down by around 20 basis points. After these changes we still need to consider the impact of term premia effects. Preliminary estimates suggest that this would require us to make a further downward adjustment to both curves beyond a six-month horizon. However, we currently have limited information on the size of the term premia that create biases in forward curves even after we have taken into account estimates of credit and liquidity premia.

The transmission mechanism of monetary policy
(56k)
This report has been prepared by Bank of England staff under the guidance of the Monetary Policy Committee in response to suggestions by the Treasury Committee of the House of Commons and the House of Lords Select Committee on the Monetary Policy Committee of the Bank of England.

The Monetary Policy Committee (MPC) sets the short-term interest rate at which the Bank of England deals with the money markets. Decisions about that official interest rate affect economic activity and inflation through several channels, which are known collectively as the 'transmission mechanism' of monetary policy.

The purpose of the paper is to describe the MPC's view of the transmission mechanism. The paper is in two parts.

Part I describes the links from official interest rate decisions to economic activity and inflation. It discusses aspects of these links such as the distinction between real and nominal interest rates, the role of expectations, and the interlinking of many of the effects mentioned. There is also a discussion of the role of monetary aggregates in the transmission mechanism.

Part II provides some broad quantification of the effects of official interest rate changes under particular assumptions. There is inevitably great uncertainty about both the timing and size of these effects. As to timing, in the Bank's macroeconometric model (used to generate the simulations shown at the end of the paper), official interest rate decisions have their fullest effect on output with a lag of around one year, and their fullest effect on inflation with a lag of around two years. As to size, depending on the circumstances, the same model suggests that temporarily raising rates relative to a base case by 1 percentage point for one year might be expected to lower output by something of the order of 0.2% to 0.35% after about a year, and to reduce inflation by around 0.2 percentage points to 0.4 percentage points a year or so after that, all relative to the base case.