The transmission mechanism of monetary policy
A change in the official rate is immediately transmitted to other short-term sterling wholesale money-market rates, both to money-market instruments of different maturity (such as rates on repo contracts of maturities other than two weeks) and to other short-term rates, such as interbank deposits. But these rates may not always move by the exact amount of t[...]
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A change in the official rate is immediately transmitted to other short-term sterling wholesale money-market rates, both to money-market instruments of different maturity (such as rates on repo contracts of maturities other than two weeks) and to other short-term rates, such as interbank deposits. But these rates may not always move by the exact amount of the official rate change. Soon after the official rate change (typically the same day), banks adjust their standard lending rates (base rates), usually by the exact amount of the policy change. This quickly affects the interest rates that banks charge their customers for variable-rate loans, including overdrafts. Rates on standard variable-rate mortgages may also be changed, though this is not automatic and may be delayed. Rates offered to savers also change, in order to preserve the margin between deposit and loan rates. This margin can vary over time, according to, for example, changing competitive conditions in the markets involved, but it does not normally change in response to policy changes alone.
Long-term interest rates
Though a change in the official rate unambiguously moves other short-term rates in the same direction (even if some are slow to adjust), the impact on longer-term interest rates can go either way. This is because long-term interest rates are influenced by an average of current and expected future short-term rates, so the outcome depends upon the direction and extent of the impact of the official rate change on expectations of the future path of interest rates. A rise in the official rate could, for example, generate an expectation of lower future interest rates, in which case long rates might fall in response to an official rate rise. The actual effect on long rates of an official rate change will partly depend on the impact of the policy change on inflation expectations. The role of inflation expectations is discussed more fully below.
Changes in the official rate also affect the market value of securities, such as bonds and equities. The price of bonds is inversely related to the long-term interest rate, so a rise in long-term interest rates lowers bond prices, and vice versa for a fall in long rates. If other things are equal (especially inflation expectations), higher interest rates also lower other securities prices, such as equities. This is because expected future returns are discounted by a larger factor, so the present value of any given future income stream falls. Other things may not be equal—for example, policy changes may have indirect effects on expectations or confidence—but these are considered separately below. The effect on prices of physical assets, such as housing, is discussed later.
The exchange rate
Policy-induced changes in interest rates can also affect the exchange rate. The exchange rate is the relative price of domestic and foreign money, so it depends on both domestic and foreign monetary conditions. The precise impact on exchange rates of an official rate change is uncertain, as it will depend on expectations about domestic and foreign interest rates and inflation, which may themselves be affected by a policy change. However, other things being equal, an unexpected rise in the official rate will probably lead to an immediate appreciation of the domestic currency in foreign exchange markets, and vice versa for a similar rate fall. The exchange rate appreciation follows from the fact that higher domestic interest rates, relative to interest rates on equivalent foreign-currency assets, make sterling assets more attractive to international investors. The exchange rate should move to a level where investors expect (1) The monetary base, M0, consists of notes and coin plus bankers’ deposits at the Bank of England..
The transmission mechanism of monetary policy a future depreciation just large enough to make them indifferent between holding sterling and foreign-currency assets. (At this point, the corresponding interest differential at any maturity is approximately equal to the expected rate of change of the exchange rate up to the same time-horizon.) Exchange rate changes lead to changes in the relative prices of domestic and foreign goods and services, at least for a while, though some of these price changes may take many months to work their way through to the domestic economy, and even longer to affect the pattern of spending.
Expectations and confidence
Official rate changes can influence expectations about the future course of real activity in the economy, and the confidence with which those expectations are held (in addition to the inflation expectations already mentioned). Such changes in perception will affect participants in financial markets, and they may also affect other parts of the economy via, for example, changes in expected future labour income, unemployment, sales and profits. The direction in which such effects work is hard to predict, and can vary from time to time. A rate rise could, for example, be interpreted as indicating that the MPC believes that the economy is likely to be growing faster than previously thought, giving a boost to expectations of future growth and confidence in general.
However, it is also possible that a rate rise would be interpreted as signalling that the MPC perceives the need to slow the growth in the economy in order to hit the inflation target, and this could dent expectations of future growth and lower confidence.The possibility of such effects contributes to the uncertainty of the impact of any policy change, and increases the importance of having a credible and transparent monetary policy regime. We return to these issues below.
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