Abstract

The principal objective of U.K. monetary policy is to influence the growth of nominal gross domestic product (GDP) over the medium term as a means of achieving price stability.51 From the mid-1970s until quite recently, the Bank of England has pursued this objective by employing monetary aggregates as intermediate targets. However, as in a number of other countries during the 1980s, the relationships between some of the targeted monetary aggregates and economic activity have been found to be generally unstable and unpredictable. Consequently, the targeting of a broad monetary aggregate (M3)52 was suspended in March 1987. Moreover, while the authorities still place importance on limiting the growth of the narrowest published monetary aggregate (M0)53 to a target range, the openness of the U.K. economy, the extremely large volume of flows into and out of the London capital market, and the associated increased uncertainty surrounding the link between the monetary aggregates and economic performance have led to a more broadly based approach to the implementation of monetary policy. In particular, a range of indicators other than monetary aggregates, such as the exchange rate, indicators of the real economy, estimates of real interest rates, the behavior of markets in financial and other assets, and the current course of nominal GDP, have also been used more recently as guides for the stance of monetary policy.54

Institutional Background and Intermediate Targets

The principal objective of U.K. monetary policy is to influence the growth of nominal gross domestic product (GDP) over the medium term as a means of achieving price stability.51 From the mid-1970s until quite recently, the Bank of England has pursued this objective by employing monetary aggregates as intermediate targets. However, as in a number of other countries during the 1980s, the relationships between some of the targeted monetary aggregates and economic activity have been found to be generally unstable and unpredictable. Consequently, the targeting of a broad monetary aggregate (M3)52 was suspended in March 1987. Moreover, while the authorities still place importance on limiting the growth of the narrowest published monetary aggregate (M0)53 to a target range, the openness of the U.K. economy, the extremely large volume of flows into and out of the London capital market, and the associated increased uncertainty surrounding the link between the monetary aggregates and economic performance have led to a more broadly based approach to the implementation of monetary policy. In particular, a range of indicators other than monetary aggregates, such as the exchange rate, indicators of the real economy, estimates of real interest rates, the behavior of markets in financial and other assets, and the current course of nominal GDP, have also been used more recently as guides for the stance of monetary policy.54

Before describing the manner in which the Bank of England implements monetary policy, it is necessary to make a few general comments about the important intermediary role played by the London Discount Market Association, an association that has no close parallel in other major countries. In the United Kingdom, banks are not required to keep reserve balances at the central bank and they do not normally go first to the Bank of England either when they are in temporary need of liquid funds or when they wish to deposit surplus liquid funds. In such circumstances, banks would generally first try to smooth out temporary liquidity imbalances with the London Discount Market Association. This association groups together a number of “discount houses”; these are private companies that are engaged primarily in intermediating between institutions with surpluses or shortages of funds and in discounting treasury or commercial bills. They are accorded a special role in the Bank’s daily money market dealings. The commercial banks can deposit more funds on call or at a short maturity in times of surplus liquidity and, in times of a shortage of funds, they can draw down their balances with the discount houses or, if necessary, borrow extra funds from them or sell bills to them. The discount houses, therefore, constitute the principal mechanism through which temporary surpluses and deficits of liquid funds are smoothed out within the banking system.

Another important role of the discount houses is to underwrite the Bank of England’s weekly treasury bill tender by tendering for all the bills on offer, with the minimum proportion of each issue tendered for by an individual discount house agreed with the Bank of England. Finally, all discount houses act as market makers for treasury bills and other bills, standing ready to buy and sell them in a secondary market.55

Operating Procedures and Instruments

The Bank of England seeks to maintain, through open market operations, both the aggregate level of banks’ operational deposits with the Bank of England (“cash”)56 and the general level of interest rates within ranges that are consistent with the overall stance of monetary policy formulated by the Chancellor of the Exchequer in concert with the Bank. Each morning the Bank estimates the cash position of the banking system, involving most importantly forecasts of government transactions with the rest of the economy. The magnitude of these transactions is typically very large and often involves wide fluctuations; hence, they often have a substantial impact on the cash position of the banking system. As the Government’s accounts are held at the Bank of England, a net flow of funds to the Government necessarily involves a decline in the balances of commercial banks; that is, cash is reduced in the absence of offsetting action by the Bank of England. Conversely, a net flow from the Government would result in an increase in cash. In its money market operations, the Bank of England aims to offset these and other net cash flows, and the terms on which it does so are likely to have general implications for interest rates, as well as indicate the current stance of monetary policy.

The first assessment of the likely shortage or surplus of funds that the banks will experience—rounded to the nearest £50 million—is announced at about 9:45 a.m. with, if necessary, a second assessment at noon that incorporates further information on flows of funds that have come to light in the intervening period. Any shortage of funds is likely to become evident early in the day, since banks tend to withdraw needed funds from the discount houses before noon. Any surplus may not become apparent until later, since banks do not tend to deposit short-term surplus liquidity with the discount houses so early in the day.

If the Bank of England concludes that there is likely to be a shortage of funds, it may inform the discount houses that it is willing to consider purchasing bills outright or, more precisely, to rediscount treasury bills, local authority bills, or eligible bank bills that they have already discounted and that have been accepted by one of a list of banks that is “eligible”57 to have its bills discounted in this way. The Bank does not usually specify which type or maturity of bill it is prepared to buy, although it can do so. The Bank deals in four maturity bands: 0—14 days, 15—33 days, 34—63 days, and 64—91 days; it does not usually purchase outright bills with a maturity greater than 91 days or eligible bank bills within 7 days of their date of acceptance.

In response to the Bank’s invitation, the discount houses communicate to the Bank the value of the bills they are prepared to sell, the type of bill involved, the maturity band of the bills, and the discount rate they are prepared to accept. The Bank considers the offers and generally buys an amount up to the estimated shortage for the day at the lowest price on offer, that is, at the highest discount quoted within each combination of instrument and band in which the Bank chooses to deal. The lowest rate of discount, that is, the highest price, at which the Bank is prepared to buy bills is known as the “stop rate,” which may differ for different maturity bands and for different types of bills. The level at which the stop rate is set can provide a signal to the market of the Bank of England’s view on the level of interest rates. A significant rise or fall in the stop rate can lead to a corresponding increase or fall in the base lending rates of commercial banks. The rates at which the Bank of England deals with the discount houses, but not the stop rate, are published ex post on wire services and in the financial press. At 2:00 p.m., a further estimate of the market’s cash position and, if appropriate, round of bill operations takes place.

The Bank may wholly or partly relieve a shortage by making straightforward loans against collateral to the discount houses at or near market rates at or after 2:45 p.m. On other occasions it may refuse to provide funds to the market at the rates on bills offered by the discount houses, thereby obliging the discount houses to borrow the money they require at the interest rate level desired by the Bank by issuing instead an invitation to borrow at 2:30 p.m. Hence, the subsequent lending is termed “2:30 p.m. lending.” If this lending rate is significantly higher or lower than the most recent dealing rates on eligible bills, a clear signal is thereby given to the commercial banks of the Bank of England’s view as to the appropriate level of their lending rates and if it is also different from the current level of bank base lending rates, a change in those rates generally follows.58

The discount houses are also entitled to offer eligible bills for sale to the Bank of England at any time and not just on invitation. This does not occur frequently and when it does, the Bank may specify the discount rate at which it is prepared to deal. If, for example, the Bank believes that in purchasing the bills it would inject more liquidity into the banking system than it felt appropriate, it could set the discount rate at a penalty level.

Most of the Bank of England’s open market operations are conducted with the discount houses, but it can on occasion deal directly with the commercial banks. The Bank does not invite bill offers from the banks, but it will consider any offers of treasury bills or local authority bills that the banks submit at the same time and in the same way as the discount houses in their response to a Bank of England offer. The commercial banks can also offer such bills after the Bank of England has concluded its normal bill dealing operations, which is generally by 2:30 p.m., but before 3:00 p.m., in which case the Bank will generally offer a lower price than that at which it purchased similar bills earlier in the day.

The Bank of England sometimes extends to the discount houses an offer to buy paper with an agreement that it will be repurchased after a given period. Such repurchase agreements tend to be offered when there are very large shortages to be accommodated and when the Bank of England does not wish to run down too drastically the supply of bills held by the discount houses. Discount houses offering bills on a repurchase basis quote a rate of interest that they are prepared to pay for the period of the agreement and the rate of interest to be paid in those agreements which the Bank of England undertakes will not normally be lower than the dealing rate set in its latest outright purchases of eligible bills. The Bank will normally set the terminal date of the repurchase agreement for a day when it expects there to be a surplus of liquidity in the money market or only a small shortage. In addition, during periods of acute cash shortages, for example during the main tax-paying periods, the Bank of England may offer the banks repurchase agreements in long-term government paper (gilt-edged stock) and in certain other assets, such as promissory notes in relation to holdings of sterling export credit and shipbuilding paper guaranteed, respectively, by the Export Credits Guarantee Department and the Department of Trade and Industry.

On occasions when there is surplus liquidity in the market, the Bank of England can absorb this excess. Surpluses are generally taken out in afternoon trading because the overall surplus is unlikely to show itself in the discount market until then. On such occasions the Bank of England will invite both discount houses and commercial banks to bid for treasury bills of one or more maturities, which it will provide to the highest bidders. Since same day settlement takes place, the Bank of England draws surplus liquidity out of the money market.

After the 1981 procedural changes mentioned above, the authorities’ policy of “over funding” the public sector borrowing requirement (PSBR) by selling more debt outside the banking sector than was needed to fund the PSBR, together with the daily draining of funds from the market caused by the maturing of bills in the banks’ increased commercial bill portfolio, meant that the Bank no longer needed to issue substantial weekly quantities of treasury bills in order to keep the market short of funds. Nonetheless, they continued with a modest weekly tender mainly to keep the treasury bill mechanism in the market intact. However, the change in 1985 to a full fund policy had led by May 1989 to a position where the Bank’s bill portfolio had shrunk and regular daily cash shortages were no longer occurring. Accordingly, the treasury bill tender was enlarged at that time, and has been £300 million to £800 million a week since then, with six-month bills issued for the first time. The Bank of England sells the bills at the prices bid by the highest bidders. It may also attempt to smooth out future expected money market shortages by including a special tender of treasury bills of other than three or six months maturity, due to mature at the time of the period of expected shortage.

Identifying Changes in Policy

In interpreting the Bank of England’s interventions in the money markets, the strongest signal of the Bank’s intention to change its stance is provided on those days when it fails to accommodate a money-market shortage through open market transactions and obliges the discount houses to borrow from it at 2:30 p.m. at a specific interest rate. If this rate is significantly higher than the effective interest rate at which the Bank had been rediscounting bills, there is a clear indication that the Bank is tightening its monetary policy. A lower rate would correspondingly indicate a relaxation of the monetary stance. The signal is all the stronger if, as in January 1985, the Bank reintroduces a fixed “minimum lending rate”; in other words, if it tells the market that it will lend only at this rate until market conditions have stabilized at interest rates considered by the Bank to be appropriate. Significant discrete changes in the Bank of England’s dealing rates—either the rate at which it rediscounts bills or its lending rate—are generally followed by a corresponding movement in the base lending rates of the commercial banks. While base lending rates are set at or close to the Bank of England’s dealing rates, interest rates on bank loans are generally set at a negotiated margin above the base rate or may be related to other rates, such as the London interbank offered rate (LIBOR), which by arbitrage relationships tend to be close to the Bank of England dealing rates. In consequence, an upward or downward movement in the Bank of England’s dealing rates generally feeds through quickly into the wider economy and indicates a change in the stance of policy.

51

This view of the principal objective of monetary policy was conveyed by Bank of England officials in an interview in July 1988.

52

M3 comprises notes and coin in circulation with the public plus all sterling deposits (including certificates of deposit) held by the U.K. private sector with U.K. banks.

53

M0 is defined as all notes and coin in circulation with the public plus banks’ till money and banks’ operational balances with the Bank of England. The annual target growth range for the fiscal year ended March 1990 was set at 1—5 percent.

55

For a description of the role of the discount houses, see Bank of England (1988).

56

There are no reserve requirements per se in the United Kingdom. However, banks do keep operational balances (called “cash”) at the Bank of England. Money market operations by the Bank affect the cash position of the banking system and hence interest rates much in the same manner as reserve management operations do in the other major industrial countries.

57

The Bank of England judges applications for eligibility according to three basic criteria: first, the bank must maintain a broadly based and substantial acceptance business in the United Kingdom; second, its acceptances must command the finest rates in the market for bills that are not considered “eligible”; and third, in the case of foreign-owned banks, British banks must enjoy reciprocal opportunities in the foreign owners’ domestic market. The bills themselves must satisfy various criteria on clausing, etc., to be eligible for purchase by the Bank.

58

The Bank could also re-establish the minimum lending rate, which served as the benchmark interest rate for several years before the procedural changes of 1981. Before then, the Bank of England generally auctioned relatively large amounts of treasury bills—up to £600 million worth each week. By this means it kept the market short of funds on a daily basis, often reinjecting liquidity by buying these bills back at a rate that was set by formula in relation to the average tender rate. When the Bank decided not to meet the demand for liquidity in this way, the discount houses would be forced to borrow from it at the more costly “minimum lending rate.” This rate served as the key benchmark interest rate and changing it had major political as well as economic implications.

In 1981, the U.K. authorities switched to what was seen as a system that would be more sensitive to market mechanisms and overcome the “bias to delay” in adjusting interest rates that was inherent in the existing system (Coleby, 1986). The weekly allocation of treasury bills was cut back to about £100 million (although it was increased again during 1989), and the Bank of England increased the amount of other commercial and local authority bills that it would purchase as well as treasury bills to relieve shortages. It was provided that if the day’s shortage was not fully offset by the Bank’s bill operations, the discount houses would have to borrow from the Bank at a rate that was at the discretion of the Bank. The Bank of England, however, explicitly retained the possibility of reintroducing a fixed minimum lending rate, and indeed it did so on January 1985 for a short period in an effort to bring some stability to rather volatile market conditions.

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