The effect of changes in official UK rates on market interest rates since 1987

It is widely accepted that a central bank, such as the Bank of England, has the ability to control very short-term interest rates. Moreover, a number of studies have documented the very close relationship between Bank-administered rates (notably the Band 1 stop rate) and their market analogues. This paper investigates the extent to which the Bank is able to influence market interest rates more generally, as opposed to just very short-term interest rates, by analysing the reaction of market interest rates to the thirty movements in the Bank's Band 1 stop rate between the beginning of 1987 and July 1991. The movements of interest rates at seven different maturities (1, 3, 6 and 12-months and 5, 10 and 20-years) were considered. The results suggest that changes in the Bank of England's Band 1 stop rate lead to significant responses in market interest rates ranging in maturity from 1-month to 5-years. These findings are supportive of the proposition that longer maturity rates are influenced by expectations of the future path of short rates, and hence in part by the current level of official rates. In addition, there was evidence of systematic movements in money market interest rates both in the days leading up to the policy change and, more surprisingly, on the day immediately following the changes. Finally, preliminary estimates suggest that the reaction of market rates increases when the change in interest rates coincides with a switch in the direction of these official changes. This may reflect the markets' recognition that when the direction of interest rate changes has just switched, the probability that this change will be reversed in the near future is lessened.