Biefang Frisanchomariscal2002

Journal of Post Keynesian Economics
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Central Banks and Market Interest Rates
Iris Biefang-Frisancho Mariscal & Peter Howells
To cite this article: Iris Biefang-Frisancho Mariscal & Peter Howells (2002) Central Banks
and Market Interest Rates, Journal of Post Keynesian Economics, 24:4, 569-585, DOI:
10.1080/01603477.2002.11490344
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Download by: [Florida Atlantic University] Date: 15 March 2016, At: 08:46
IRIS BIEFANG-FRISANCHO MARISCAL AND
PETER HOWELLS
Central banks and market interest rates
Abstract: In a world of endogenous money, the central bank's role in monetary

policy is reduced to the setting of a very short-term official rate of interest,
which indicates the price at which it will make liquidity available to the bank-
ing system. However; it is changes in market rates that affect behavior; and so
Downloaded by [Florida Atlantic University] at 08:46 15 March 2016
the ability of the central bank to influence anything at all depends, first, on the
interaction between official and market rates. In this paper; we use a vector
autogressive error correction model to explore the response to changes in the
central bank rate of three short-term market rates that have beenfeatured pre-
viously in this journal in debates about the demand for endogenous money.
Key words: central banks, interest rates, monetary policy.
Since the mid-1970s, the evolution of monetary policy in most coun-

tries has seen a steady increase in market orientation. In practice, this
has meant the removal of direct controls, reductions in reserve require-
ments, an increasing emphasis on interest rates as an operating target,
and a shortening of the maturity of rates directly involved (see BIS,
1997, for a survey of monetary policy "tactics," and Borio, 1997, for a
survey of central bank operating procedures).
The way in which a change in official rates is eventually communi-
cated to the behavior of nominal income (the "transmission mechanism
of monetary policy") varies, to some degree, between countries, doubt-
less because it depends, to some degree, on institutional differences be-
tween economies (Britton and Whitley, 1997). In the United Kingdom,
a change in interest rates works mainly through demand, with a small
effect coming directly from import prices. The links between interest
rates and demand are provided by wealth effects, the exchange rate, the
cost of credit, and the incentive to trade present for future consumption
The authors are, respectively, Senior Lecturer and Professor of Economics at the
University of East London, Essex, United Kingdom.
Journal of Post Keynesian Economics I Summer 2002, Vol. 24, No.4 569
© 2002 M.E. Sharpe, Inc.
0160-3477 12002 $9.50 + 0.00.
570 JOURNAL OF POST KEYNESIAN ECONOMICS
(Monetary Policy Committee, 1999). It seems reasonable to suppose

that most, if not all, of these links are operative in other regimes, al-
though maybe with different strengths.
However, the first link in the chain, in all monetary regimes, is the link
between official rates and market rates. It is not the rate at which the
central bank supplies liquidity to the domestic banking system that
changes demand pressure. It is how agents react to changes in the rate
on loans charged by banks, to changes in asset values that flow from a
different rate of discount, to changes in the rate that they earn on their
savings, and so on. All monetary regimes that use interest rates as the
operating target must naturally assume a fairly ready link between offi-
cial and market rates.
But what a particular regime requires of this link (other than that it be
predictable) is far from obvious a priori, and what a particular regime
actually gets in this link is completely obscure a priori and can be estab-
lished only with some empirical difficulty, as we shall show in this paper.
In the next section we look at what sort of response the authorities
might like to have in an ideal world. We show first that a direct and
proportionate link between the official rate and market rates is not nec-
essarily what is wanted, and that what is almost certainly required is a
complex set of changes in relative rates. We demonstrate this using a
transmission mechanism that relies rather heavily on the growth of money
and credit-a bit outdated (1980-1985), but with the merit of simplic-
ity-but also by reference to the transmission mechanism as currently
understood by the Bank of England.
In the third section, we look at some of the earlier work that has been
done in this area so as to clarify both what we are looking for and our
approach and also to note some of the empirical difficulties, which are
considerable. In the fourth section, we examine the behavior of the UK's
official rate and three market rates, giving us three relativities of which
behavior against the official rate we explore. The empirical examination
uses a vector autoregressive error correction model (VECM). The fifth
section summarizes and concludes.
Official and market interest rates
When central banks change interest rates, strictly speaking, the rate that
they change is the "refinancing" rate, the rate at which liquidity is made
available to the banking sector. It is only in the market for reserves that
the bank is the monopoly supplier, and only In that market that it can
determine price directly (Dale and Haldane, 1993, p. 3). In the words of
CENTRAL BANKS AND MARKET INTEREST RATES 571
the Bank of England's deputy governor, "the Bank [of England] sup-
plies base money on demand at its prevailing interest rate, and broad
money is created by the banking system" (King, 1994, p. 264). What
happens as broad money is created is determined by behavioral interac-
tions among private sector agents. "What happens" includes what hap-
pens to market interest rates, the ones that genuinely impinge on real
economic activity.
Precisely what rate a central bank decides to operate on is a matter of
local choice and will reflect the structure of national money markets and
banks' portfolio preferences. In the United Kingdom, for example, from
1971 to 1997 the Bank of England relied mainly on outright sales/pur-
chases of Treasury bills of "band I" (up to 14 days maturity) and occa-
sionally "band 2" maturity (15-33 days). Since 1997, it has been much
more active in the gilt repo market, making sale and repurchase agree-
ments in government bonds. Such deals are commonly still for 14 days
(Bank of England, 1997). Changes in this rate will be communicated to
financial markets by a mixture of convention and arbitrage. Initially, the
impact will be felt in short-term money markets, becoming more re-
mote as we move along the maturity spectrum and as expectations (inter
alia) playa larger part. In most regimes, the impact at the short end will
be very quick indeed.
But what precisely will the impact be, and what sort of impact would
make for the most effective conduct of monetary policy? Clearly, with-
out satisfactory knowledge of how changes in official rates connect with
market rates it is impossible to know what change in official rates is
necessary to achieve a given result.
Faced with the question "what would make for the most effective link
between official and market rates?" one tempting answer is that market
rates should ideally move equally in step. In this case, a 50-basis-point
increase (for example) in official rates would see mortgage, overdraft
and deposit, bill, and short-bond rates all rise by one-half of 1 percent.
But a moment's reflection calls this into doubt. We assume, as a rule,
that agents change their behavior in response to changes in relative prices.
If one wishes the interest rate increase to reduce the demand for money,
for example, it would be extremely helpful if all, or most, of the 50-
basis-point increase found its way through to near-money substitutes in
its entirety, leaving deposit rates themselves largely unchanged. Whether
or not this happens is likely to depend more than somewhat on features
of the domestic monetary system as we next show very clearly.
At various times in the last 30 years, UK monetary policy has been
preoccupied with the growth rates of money and credit. This was most
evident in the period of explicit monetary targets between 1980 and 1985;
but less explicit targets first surfaced in 1967, and credit growth rates
are still monitored as part of the information set on which the Monetary
Policy Committee bases its interest rate decisions. Until 1971, expan-
sion had been controlled by a mixture of direct controls, moral suasion,
and occasional interest changes. The "competition and credit control"
arrangements, announced in 1971, changed all this by removing all re-
strictions on bank lending in return for a simultaneous end to the banks'
interest rate cartel and other noncompetitive practices. The refinancing
rate ("bank rate") was to be the primary operating instrument. As is well

known, events during the 1970s knocked this policy somewhat off course,
and frequent emergency resort to direct controls (in the form of the "cor-
set") were required. The primacy of interest rate control was reasserted
in 1980 and has been virtually the sole monetary policy instrument ever
since. For students of monetary economics, the question naturally arises
of how, exactly, changing the lender-of-Iast-resort rate is expected to
influence the growth of money and credit. The answer is not as simple
as it seems.
We begin with the flow offunds identity in which changes in the money
stock are decomposed into their credit counterparts and in which the
change in bank lending to the nonbank private sector is identified as the
dominant source of monetary growth. Provided the increase in official
rates is passed on by banks as an increase in loan rates, then we move up
a demand curve for bank lending and the flow rate of new loans (and
hence deposits) is reduced. On the evidence since 1971, banks have been
quite willing to pass on this change (though we shall note some qualifi-
cation to this in the next section). More problematic for the bank was
the apparent inelasticity of the loan demand curve with respect to the
loan rate.
In the early days, however, this was partially obscured by another in-
terest rate effect. This arises because the demand for loans (like the de-
mand for most products and services) depends, in part, on the cost of
substitutes. The demand function for loans that we have in mind (see
Dale and Haldane, 1993, pp. 6-7) is
(1)
where Ld is the demand for bank loans, it and ib are the rates charged on
bank loans and paid on short-dated bonds, respectively, and y is the level
of nominal income.
Before "competition and credit control," banks operated an interest rate

cartel with the result that interest was paid on just a subset of deposits
and at rates that were low compared with other nonmoney liquid assets.
More importantly, they were decidedly sticky. The consequence of this
was that a rise in bank rate communicated itself much more readily to
loan rates (as we have seen) and to rates on nonmoney assets than it did
to money itself. This remained true throughout the 1970s, although the
effect diminished as banks began at least to compete between themselves
for wholesale deposits. A second effect of a bank rate increase is now
apparent in these particular circumstances-it increases the opportunity
cost of money. In so doing, it naturally induces a switch from money to

nonmoney assets, and whatever effect the increase in official rate may
have had on short-dated securities is attenuated by the switch out of money.
Relative changes now come thick and fast. The rate on loans and the rate
on nonmoney assets have both risen relative to the rate on money. But
because of the switch out of money, the rate on nonmoney assets has
risen by less than the rate on loans. Consequently, the rate on bank loans
has risen relative to the rate on nonmoney assets. This may seem to be of
limited interest, until we recognize that nonmoney assets are someone's
liabilities and were issued to fund a deficit and, partly therefore, as an
alternative to borrowing from banks. The end result of this sequence (see
Equation (1)) is that nonbank finance (ib) has become cheaper relative to
borrowing from banks. Returning to our demand curve for bank loans, its
inelasticity is somewhat disguised, from the point of view of policy ef-
fectiveness at least, by a leftward shift as the price of a substitute product
declines. So long as money's own rate is sticky, therefore, changes in
official rates bear upon money and credit growth by simultaneously shift-
ing agents up and down the bank loan demand curve and simultaneously
shifting the curve. Plotting actual loan growth rates against the rates
charged on bank lending produced a curve, which was a locus of points
created by the intersection of loan rates with a series of loan demand
curves. The demand for loans seemed reasonably elastic.
It does not take much imagination to see that this benign combination
is sundered once money's own rate becomes market sensitive. This is
what happened progressively through the 1970s, and much more dra-
matically in the 1980s, when deregulation led to competition between
banks and building societies for retail deposits. In these circumstances,
an increase in the official rate, accompanied now by a similar rise in
deposit rates, no longer increased the penalty for holding money. With-
out that, there is no portfolio rearrangement to limit the increase in rates
on non money assets and thus to cheapen nonbank sources of finance. In
our imaginary diagram, our demand curve is unmoved and the reduc-
tion in the flow of new bank loans is limited to whatever the inelastic
demand curve permits. Plotting realized loan growth rates against lend-
ing rates revealed the true inelasticity of demand with respect to the
absolute rate charged on bank loans.
For aficionados of two-dimensional diagrams, the obvious revelation
in all of this is that the price of bank loans would be better represented
as a spread term showing the difference between the cost of bank fi-
nance versus nonbank alternatives. This is what Goodhart had in mind
in reflecting upon the changes we have just described.

It is not that the demand for lending has become less sensitive to changes
in relative interest rates. If anything, it has become more so. The problem
lies in the increasing inability of the authorities to cause changes in rela-
tive rates by changing the level of absolute rates. (Goodhart, 1984)
This illustration has involved three interest rates (and hence three
spreads). These are money's own rate, the rate charged on bank loans,
and the rate of return on nonmoney assets, and we have shown their rel-
evance to one type of policy regime, where money and credit growth are
the intermediate targets. In other regimes, other rates and relativities will
be involved, although it seems likely that "other" rates will be in addition
to, rather than substitutes for, "money," "loan," and "bond" rates. In the
UK transmission mechanism as currently conceived, for example, indi-
viduals are affected by monetary policy because a change in official rate
means "they face new rates of interest on their savings and debts . . .
[furthermore] ... higher interest rates (current and expected) tend to re-
duce asset values, and lower wealth leads to lower spending" (Monetary
Policy Committee, 1999, p. 6). Clearly, in the first of these two mecha-
nisms, monetary policy would be stronger if it could be made to operate
upon the loan-deposit spread (such that it widened), rather than upon
both individual rates equally. For firms, "[t]he rise in interest costs re-
duces the profits of such firms and increases the return that firms require
on new investment projects" (Monetary Policy Committee, 1999, p. 7).
Again, a policy that altered the cost of borrowing relative to deposits
would be more powerful than one that left relativities unchanged. Thus,
whatever the regime, and whatever the intermediate targets of policy, it
seems unlikely that relative rates will be unimportant. And in many of
these spreads, money, loan, and bond rates will be important, even if they
may not be all that matters.
In the next section, we take a brief look at what we already know and
at how we intend to advance from there.
The evidence so far

Given that monetary policy now consists (as Post Keynesians have ar-
gued for many years) of interest rate policy and since central banks can
control a rate of interest, which itself affects real economic activity only
indirectly, it is not surprising that the connection between official and
market rates has been the focus of attention on a number of occasions.
In the United Kingdom, for example, Spencer Dale examined the link
between the Bank of England's "band 1 stop rate" and market interest
rates at maturities of 1,3,6, and 12 months and 5, 10, and 20 years, for
30 changes in that stop rate between January 1987 and July 1991 (Dale
1993). His findings were that

• the response of market rates was generally positive, but often "over-
shot" the change in official rate (that is, changed in the same direc-
tion by more than 100 percent of the official change);
• the effect decayed with term to maturity;
• the effect (at all maturities) in 1988 was negative;
• the effect was greatest at turning points of the interest cycle.
The examination consisted of estimating the equation
(2)
where I:lMR(i) is the change in the market rate of maturity i on the day of
the nth change; /).stop is the nth change in the bank's band 1 stop rate;
i = 1,3,6 months, ... ,20 years; n = 1,2,3, ... ,30; and Ein is an error term.
The first two results were what one would expect. Furthermore, as-
suming that short rates are generally below long rates, the second result
tells us something about long-short spreads-they narrow when official
rates rise and increase when official rates fall. But they tell us nothing
about the behavior of loan-deposit or bond-deposit spreads (the short
rates are all interbank rates, whereas the longer rates are all bond par
yields) (Dale, 1993, p. 89).
What happens to spreads between different instruments may be quite
complicated. This is suggested in another study that attempts to model
the effect of an official interest rate change in a model of monetary policy
by Dale and Haldane (1993). As they point out, the "pass-through ef-
fect" (of official to market rates) will depend, inter alia, on the behavior
of bank margins. If these are adjusting either over time or across the
interest rate cycle, then the pass through to loan and deposit rates will be
affected. Furthermore, as we saw in Equation (1), the Dale and Haldane
model l recognizes that the demand for bank loans will depend, to some
degree, on the bond yield. But, for some sectors of the economy, the
substitutability between bank credit and bond finance is very imperfect.
Households, for example, find it difficult to access nonbank sources of
credit-bank credit is "special" for them. This reduces the competitive
forces that might keep bond and bank loan rates in equilibrium and will
make bank loan rates "sticky." This effect is likely to be accentuated by
the fact that bond rates are determined within an auction market, whereas
bank interest rates (on loans and deposits) are set by banks' administra-
tive decision (Dale and Haldane, 1993, pp. 16-19).
They also look at the effect of a change in official rates on market

rates. The independent variable is UK banks' base rate changes between
March 1987 and October 1992. Market rates are differentiated by type
of asset/liability rather than term, as in Dale (1993). The method used
was the event-day study, familiar in studies of financial markets' re-
sponse to news, but also used in this context by Cook and Hahn (1989).
The findings this time were:
• The mean response of all the market rates to a base rate change is
positive but significantly less than 100 percent.
• The responsiveness of market rates is lower the lower the degree
of substitutability for the nonbank private sector is. Thus, the re-
sponse to an official rate change is about 30 percent for personal
loans and credit card debt, 38 percent for corporate loans, above
50 percent for mortgage and deposit rates.
Interestingly, from our point of view, their conclusion is that
As market rates are sticky, the marginal impact may be less [sic] and
potentially much less, than suggested by a given base rate change. More-
over, this stickiness suggests that such spreads may contain useful infor-
mation about the effective stance of monetary policy and hence future
movements in activity following a monetary policy shock. (Dale and
Haldane, 1993, p. 21)
The stickiness of market rates has also been extensively investigated
by Shelagh Heffernan (1993, 1997). Following anecdotal evidence of
bank and building society failure to pass on interest rate cuts to loan
customers, Heffernan (1993) showed that the retail banking market was
one of complex imperfect competition with sluggish loan and deposit
1 An extension of the Bemanke and Blinder (1988) model.

rate adjustment, with the London Interbank Offer Rate (LIB OR) proxy-
ing the official rate.
More recently, Heffernan (1997) used an error correction approach to
explore the short- and long-run responses of rates on a number of bank-
ing products to changes in official rates. The model was initially esti-
mated for seven different retail bank products using data from four large
clearing banks, a number of smaller banks, and five large building soci-
eties, covering the period (at longest) May 1986-January 1991.
On average, adjustments of checking accounts and mortgages were 37
percent complete within a month, but much slower for personal loans.
The imperfect competition, noted in the 1993 paper, was one reason for
the slow response, reinforced by administrative costs. Interestingly,

Heffernan makes a comparison with the pre-1971, pre-"competition and
credit control" era when banks operated an interest rate cartel. In these
circumstances, she notes, prices adjusted much more quickly because
banks linked their product costs/returns directly to official rates by a
conventional markup. Changes were mechanical and instantaneous.
In addition to these studies, a number of papers suggest that financial
spreads are useful indicators of real activity. The best known of these is
probably Stock and Watson (1989), but Davis (1992) and Davis and Henry
(1993) focus specifically on the United Kingdom. The idea behind these
studies is that changes in spreads tell us something about the market's
perception of changing risk. Thus, for example, a widening of the cor-
porate-government bond spread suggests that (the market thinks) the
risk on corporate bonds is increasing. From this we may then be able to
infer (the market's perception of) forthcoming slowdown or even reces-
sion. Tests of these spreads (and of financial markets' expectations as a
substitute for macroeconomic forecasting) have generally been positive.
Including financial spreads in vector autoregressive (VAR) models of
output and prices improves our ability to anticipate turning points. Other
than documenting further the importance of interest rate relativities (and
maybe teaching us something about methodology), however, these stud-
ies have little relevance to the present issue. They are not concerned
with short rates, and they make no reference to the central bank rate.
What many of these studies show is that the simplifying assumption,
often made, that a change in official rates is representative of across-
the-board interest rate changes is misleading. This may not always mat-
ter (if we are exploring the equilibrium properties of the IS-LM model
in the classroom, for example). But it may be important when it comes
to understanding the transmission mechanism and, in particular, when it
comes to empirical investigation.
In the second section, we noted that changes in relative interest rates

will often be important, and what all these studies show is that changes
in relative rates are almost inevitable, given the imperfect and lagged
adjustment of individual rates to change in official rates. Furthermore,
as Heffernan (1997) noted, the way in which relative rates behave may
well be influenced by major regime shifts like "competition and credit
control." But none of the studies, however, enables us to say anything
directly about the relative rate changes that we are interested in. To draw
any conclusions about an official market rate spread, one has to look at
how each market rate responds to the official rate and then make a num-
ber of assumptions. Working like this, we saw, for example, that Dale's
(1993) results allowed us to infer something about long-short spreads.
But this does not help us much if we wish to know what happens to the
(very short) loan-deposit spread, for example, or to the relative cost of
bank and nonbank finance, which Dale and Haldane (1993) recognize is
important. In a rather similar way, we might infer something about the
immediate impact of an official rate change on selected differentials
from Heffernan, bearing in mind the different speeds of adjustment of
different products, but the temptation to do this is severely affected by
Heffernan's own observation that the range of coefficients across insti-
tutions suggests that there are big differences in the pricing of personal
loans and also "confirm[s] that banks and building societies differ widely
in the way they price deposit products" (Heffernan, 1997, p. 224).
In this paper we try to address more directly the behavior of three
spreads in response to changes in the official rate. The rates on which
we concentrate are the short bond rate (SBR), the rate available on gov-
ernment bonds with five years to maturity; a deposit rate (DR), which is
the rate on seven-day notice accounts for the London clearing banks
from 1975(1) to 1983(12) and the average rate on instant access savings
accounts of the four main London clearing banks from 1984(1) to
1998( 12); a lending rate that is proxied by three-month LIBOR; and the
official rate, which is a one-month Treasury bill rate (TBR). In this latter
case, a proxy is necessary if we are to have a long run of observations,
since the official intervention rate has changed over the years. Today's
rate (the rate on 14-day gilt repos) goes back only to 1997. Like all
proxies, the TBR is imperfect but has the advantage that, prior to 1997,
it was either the explicit official "stop" rate (Dale, 1993, p. 78) or, when
a minimum lending rate (announced or unannounced) was used during
the 1970s, was linked by a fixed margin to the official rate. Changes in
the TBR will therefore match changes in the official rate, whatever it
may be called.
Generally, we have monthly observations from 1975(1) to 2001(3).

One exception is three-month LIBOR, which starts only in 1978(1). The
other is the DR, whose publication ceased in 1998(12). We experimented
by extending the series by (a) a rate on one-month certificates of depos-
its (DR1) and (b) a weighted deposit rate on time deposits (DR2).
Empirical results
Ideally, we should like to estimate directly the relationship between each

individual spread (such as LIB OR-DR) and the official rate (TBR). The
literature generally acknowledges that interest rates are integrated of

order one (Hall et aI., 1992). However, there is also some evidence that
interest rates tend to cointegrate pairwise (Cuthbertson et al., 2000).
Although this result may vary with the frequency of the data and the
sample period, it may cause a potential problem when we estimate a
direct relationship between the spreads as described in the theoretical
part of the paper and the TBR. If the interest rates in the spread do
cointegrate, then the spread variable is the integrated of order zero. Since
TBR has a unit root, the estimation would combine two variables of
different order of integration. In this case, a sensible economic relation-
ship in which TBR explains the spread cannot be estimated. We there-
fore estimate pairwise cointegrating relationships between the interest
rates that are part of the spreads and the TBR, applying Johansen's
cointegration method. On the basis of these results, we can infer and
then discuss the effects of changes in TBR on the spread terms.
We took care in the specification of the unrestricted VAR (UVAR)
models, since the rank tests are affected by violations of the white-noise
assumption of the residuals. The UVAR models were estimated with a
lag length of 13. For most models, this length seemed to be appropriate
to avoid serial correlation. As many impulse dummies as necessary were
included in order to avoid heteroscedasticity and violations of the nor-
mality assumption. The diagnostic test results of the UVAR models can
be obtained from the authors on request.
On the basis of the well-specified UVAR models, cointegration rela-
tionships were estimated in which the constant was restricted to lie in
the cointegration space. Over the entire period, we could only find a
cointegrating relation between LIBOR and the TBR. For the DR and
SBR, we had to split up the period in 1986. The results of the cointegration
tests over the subperiods are presented in Tables la and lb.
We find five cointegrating relationships, which are presented in Table 2.
We could not find a sensible cointegrating relation between the DR and
Table 1a
Cointegration tests: 1975(1 )-1985(12)
Maximum
Variables Null hypothesis eigenvalue test Trace test
LlBOR, TBR 26.62** 34.47**

7.86 7.86
DR, TBR No sensible
cOintegration
SBR, TBR 18.63* 20.54*
1.91 1.91
Notes: * denotes that the test statistic is significant at the 5 percent level; ** denotes that
the test statistic is significant at the I percent level.
Table 1b
Cointegration tests: 1986(1 )-2001 (3)
Maximum
Variables Null hypothesis eigenvalue test Trace test
LlBOR, TBR r =0 18.00* 24.43*

r~ 1 6.43 6.43
DR2, TBR r =0 17.81* 20.51*
r:-;; 1 2.71 2.71
SBR, TBR r =0 22.44* 23.87*
r~ 1 1.43 1.43
Notes: * denotes that the test statistic is significant at the 5 percent level; ** denotes that
the test statistic is significant at the 1 percent level.
TBR before 1986. We tested the cointegrating relations by imposing a

coefficient of one on TBR and by testing for weak exogeneity of TBR.
The first restriction was accepted in four out of the five estimated relation-
ships. Weak exogeneity ofTBR was only accepted in two of the presented
estimations, namely in the DR2 and LIBOR equations during the 1986 to
2001 period. We also tested whether SBR, LIBOR, and DR2 were weakly
exogenous. Weak exogeneity of these interest rates was rejected in all
cases. The implications of the statistical rejection of the weak exogeneity
assumption of TBR are that there are feedback effects from SBR and
LIBOR (in the earlier period) to TBR. The validity of the imposed restric-
tions is indicated by the chi-squared statistic displayed in Table 2.
For the period starting in 1986, the interest rates cointegrate with TBR
with a coefficient of one, implying that a change in TBR is fully ab-
sorbed by the bond rate, DR, and LIBOR. This is also the case for LIB OR
Table 2
Cointegration vectors and adjustments
1975(1 )-1985(12) 1986( 1)-2001 (3)
UBOR = TBR + 0.001 a UBOR = TBR + 0.253

(0.09) (0.03)
a = -0.574 a =-0.472
(0.15) (0.12)
x2 (1) = 3.70 [0.054] x2 (2) = 0.08 [0.96]
SBR = 0.472TBR + 6.569 SBR = TBR + 0.468
(0.7) (0.82) (0.34)
a = -0.219 a= -0.03
(0.06) (0.015)
x2 (1) = 0.41 [0.52] X2 (1) = 0.48 [0.49]
No cointegrating vector DR2 = TBR - 2.60b

(0.30)
a =-0.05
(0.015)
X2 (2) = 5.23 [0.073]
Notes: a The sample period begins in 1978(1). In view of comparability in our interpreta-
tion, we estimated the relationship between SBR and TBR for this shorter period. The
result did not change significantly.
b We tried to capture the break in 1998, by an impulse dummy, which appears to have
accounted for the change in the interest rate series. To be on the safe side, we reestimated
the relationship until 1998(12), and there was no significant difference in the cointegra-
tion results. Standard errors are in parentheses.
and TBR in the period before 1986, since this relationship has remained
unchanged over the entire period.
First, we discuss the effect of a change in TBR on the spread between
SBR and LIBOR in the period before 1986. In the long run, a 1 percent-
age point rise in TBR reduces the spread by about 0.5 percentage points.
The adjustment toward the new equilibrium is so that the spread widens
in the first months due to the faster adjustment in LIB OR. Once the ad-
justment in LIBOR is completed, the width of the spread falls to its new
equilibrium level. In our earlier discussion, we noted that a central bank
wanting to restrict the growth of money and credit would find it helpful
if, when it pushed up loan rates, the cost of nonbank borrowing (such as,
by issuing bonds) were to fall relative to bank loan rates. Such does seem
to have been possible before 1986, once adjustment was complete.
We turn now to the discussion of the spreads in the more recent pe-
riod. In the long run, the spread between LIBOR and the deposit rate is
about 2.9 percentage points. A change in the TBR adjusts LIBOR fully
after about two months. The adjustment of the deposit rate is rather
slow, so that during the process of adjustment to a central bank increase,
the spread first widens and then declines slowly to "normal." In policy
terms, therefore, it seems that a rise in the official rate is able to raise the
cost of borrowing relative to money's own rate (generally helpful in a
monetary tightening), but this effect is strictly temporary. Raising offi-
cial rates has no lasting effect in raising the cost of borrowing relative to
using existing liquid assets.
The spread between the bond and deposit rates in recent times is com-
plicated by the large standard error (0.34), which suggests a confidence

level of only 82.lfthe result is significant, then the bond-deposit spread
is positive in the long run with a value of about 3.07 points (2.60 +
0.468). If, however, we discard the SBR-TBR relationship as pure noise,
then the value may be only 2.6 percentage points. More interesting, the
adjustment is very slow for both interest rates, but approximately the
same, so that once again a change in official rates has little noticeable
effect on the spread.
The equilibrium value of the spread between the bond and LIBOR
rates is similarly complicated. If the SBR 0.468 mark up over TBR is
discarded, then we are left with an SBR-LIBOR spread of -0.253 per-
centage points. Turning to short-term adjustment to a rise in TBR is
fastest on the LIBOR rate so that (on the assumption of insignificance),
initially, the spread widens and slowly declines to its equilibrium value.
If we accept the significance of the SBR markup, then the position is
reversed. LIBOR still adjusts more quickly, but now moves up toward
the bond rate in its initial adjustment before falling back. What we do
seem sure about is that a change in official rates again has no lasting
effect on the difference between bond rates and lending rates. This is
quite different from our findings from the earlier period where changes
in the official rate were able to produce a significant and lasting change
in the bond-lending differential.
Overall, therefore, this very preliminary examination of the data sug-
gests that (a) a change in official rates has little lasting effect on relative
rates, although there are short-run impacts that result from differential
speeds of adjustment in individual rates, and (b) this marks some change
from the pre-1986 period when lasting changes were possible. Thus,
insofar as the effectiveness of monetary (interest rate) policy relies on
being able to change relative rates at the short end, this effectiveness
appears to have weakened as a result of changes in the 1980s. The ques-
tion is "what was so significant about 1986?"
Where spreads involving deposit rates are concerned, a steady erosion

of the central bank's ability to induce changes in spreads is not wholly
surprising. Wholesale liability management, as a result of which banks
began to offer competitive and (more important here) market-related
rates, began after the introduction of "competition and credit control" in
1971, although the trend was badly disrupted by recurrent impositions
of the corset during the 1970s, which removed the banks' incentive to
bid for deposits. After the 1981 restatement of interest rates as the sole
instrument of policy, however, the trend resumed. Furthermore, it was
reinforced by the competition between banks and building societies for
retail custom, which broke out in the mortgage market in 1981 and quickly
spread to deposits. The building society interest rate cartel broke up in

1983. Then, with the Building Society Act of 1986, building societies
were able to engage in unsecured lending and thus for the first time to
issue check guarantee cards. Competition was ratcheted up further as
banks began to offer interest (at market-related rates) on all deposits.
The fact remains, however, that this was a progressive trend, and there is
no particular reason to have expected 1986 as the critical turning point.
Maybe this was how long it took for the majority of deposits to acquire
market-related rates.
Whether our inability to find cointegrating vectors for any spreads
involving deposits prior to 1986 is explained by a banks' unwillingness
to pay market-related deposit rates is another matter. Certainly, the cor-
set would have disrupted many interest relationships in the 1970s (that
was its purpose after all!), and before that there was no need for deposit
rates to follow any other rates.
Summary
Given the fact that official short-term interest rates have become the
sole instrument of monetary policy for most central banks, it is not sur-
prising that the question of how changes in the official rate affect the
market rates that actually matter to economic activity should have re-
ceived considerable attention. However, studies hitherto have never quite
concentrated on the relationship between the official rate and other rates
that we are interested in here. In Dale (1993), for example, the market
rates were rates on interbank deposits and bonds (no loans) and ranged
from one month to 20 years. In Heffernan (1997), the rates were all
short rates, on a formidable range of bank products, and in such detail as
to show up differences across institutions. But there was no reference
here to bonds or other auction-market instruments. In no case was there
an explicit examination of spreads, although it is frequently acknowl-

edged that changes in relative rates may be important.
In this paper, we have taken a first step by looking at just three that,
unlike any of the earlier studies, enable us to tease out evidence on the
complicated interaction between the demand for money, credit, and
money and credit substitutes. It can be argued, of course, that there are
many more, and it might be argued that the variables we have selected
are not the best representatives of the spreads we have in mind. They are
certainly highly aggregated, and it would be interesting to see how dif-
ferent types of loan rates or deposit rates of different sizes of banks

responded to each other and to different bill and bond rates. But this is
for the future. Furthermore, we have to recognize that policy must be
made with regard to broad aggregates. It is what happens to the loan-
deposit spread on average that the Bank of England must consider.
What we have seen is first that there is a long-run relationship be-
tween three key rates and the level of official rates since 1986. This
makes it difficult for the Bank of England to induce lasting changes in
relative rates, in pursuit of its monetary objectives, by any change in its
official rate. This situation seems to have been less clear before 1986
when it was possible at least to induce enduring changes in the loan-
bond spread. Changes in differentials do occur in response to central
bank interest rate changes, but these are temporary and result from dif-
ferential speeds of adjustment.
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Journal of Post Keynesian Economics

ISSN: 0160-3477 (Print) 1557-7821 (Online) Journal homepage: http://www.tandfonline.com/loi/mpke20

Central Banks and Market Interest Rates

Iris Biefang-Frisancho Mariscal & Peter Howells

To link to this article: http://dx.doi.org/10.1080/01603477.2002.11490344

Published online: 03 Nov 2015.

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Central banks and market interest rates

Abstract: In a world of endogenous money, the central bank's role in monetary

Key words: central banks, interest rates, monetary policy.

Since the mid-1970s, the evolution of monetary policy in most coun-

(Monetary Policy Committee, 1999). It seems reasonable to suppose

Official and market interest rates

rate ("bank rate") was to be the primary operating instrument. As is well

Before "competition and credit control," banks operated an interest rate

cost of money. In so doing, it naturally induces a switch from money to

in reflecting upon the changes we have just described.

The evidence so far

1993). His findings were that

They also look at the effect of a change in official rates on market

1 An extension of the Bemanke and Blinder (1988) model.

the slow response, reinforced by administrative costs. Interestingly,

In the second section, we noted that changes in relative interest rates

Generally, we have monthly observations from 1975(1) to 2001(3).

Ideally, we should like to estimate directly the relationship between each

literature generally acknowledges that interest rates are integrated of

LlBOR, TBR 26.62** 34.47**

LlBOR, TBR r =0 18.00* 24.43*

TBR before 1986. We tested the cointegrating relations by imposing a

1975(1 )-1985(12) 1986( 1)-2001 (3)

UBOR = TBR + 0.001 a UBOR = TBR + 0.253

No cointegrating vector DR2 = TBR - 2.60b

plicated by the large standard error (0.34), which suggests a confidence

Where spreads involving deposit rates are concerned, a steady erosion

spread to deposits. The building society interest rate cartel broke up in

an explicit examination of spreads, although it is frequently acknowl-

ferent types of loan rates or deposit rates of different sizes of banks

- - - . "Modeling British Interest Rate Adjustment: An Error Correction Approach."

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LlBOR, TBR 26.62 34.47