Q&A: Why when base rates change does it cause other interest rates to also change?

Q&A: Why when base rates change does it cause other interest rates to also change?

The concise answer is that the Bank of England acts as the nation’s central bank and it can use its daily operations in the money markets to nudge other interest rates higher or lower.

The Bank of England fact sheet on monetary policy makes clear that:

“As banker to the Government and the banks, the Bank is able to forecast fairly accurately the pattern of money flows between the Government’s accounts on one hand and the commercial banks on the other, and acts on a daily basis to smooth out the imbalances which arise. The Bank supplies the cash which the banking system as a whole needs to achieve balance by the end of each settlement day. Because the Bank is the final provider of cash to the system it can choose the interest rate at which it will provide these funds each day. The interest rate at which the Bank supplies these funds is quickly passed throughout the financial system, influencing interest rates for the whole economy. When the Bank changes its dealing rate, the commercial banks change their own base rates from which deposit and lending rates are calculated.”

When the monetary policy committee changes base rates it is sending a signal to the rest of the financial markets as to the direction in which it wants interest rates to move. In February 2009 the official policy rate was cut by 0.5% (or 50 basis points) to an historic low of 1%.

There is no guarantee that a change in base rates will cause all other interest rates to move too. That depends on the commercial decisions taken by the banks, building societies and other financial institutions.

Some mortgage lenders for example have chosen not to pass on all of the recent interest rate cuts because they feel it is no longer profitable for them to charge such low rates on home loans, and because they might also have to cut rates on offer to depositors at a time when the lenders need to rebuild their balance sheets by attracting fresh funds from private savers.

Mortgage rates are determined not simply by Bank of England decisions but by trends in the demand for home loans and by the available supply of credit including interest rates in wholesale money markets from where many commercial lenders of money based on the High Street get some of their funds. Other factors include expectations of inflation and also the credit worthiness of the person wanting to borrow the money.

The interest rates on credit cards have also remained relatively immune from the deep cuts in base rates made by the Bank of England since the economic crisis started. Indeed the average cost of paying a bank overdraft has increased!

One interest rate that economists now pay close attention to is the LIBOR – the London Interbank Offer Rate – which is basically the rate of interest that the banks charge to each other for overnight (very short term) lending and borrowing. This normally tracks the base rate very closely, but the uncertainties created by the credit crunch caused the LIBOR rate to drive higher than the base rate by some distance. The gap is closing but it remains wider than it was a few years ago.