Interest Rates

The Bank's influence on short-term interest rates arises from its role in the domestic money markets. As banker to the government and to the banks, it is able to forecast fairly accurately the pattern of flows between the government's accounts on the one hand and the commercial banks on the other, and acts on a daily basis to smooth out the imbalances, which arise. When more money flows from the banks to the government than vice versa, the banks' holdings of liquid assets are run down and the money market finds itself short of funds. When more money flows the other way, the market can be in cash surplus, but the pattern of government and Bank operations usually results in a shortage of cash in the market each day - a shortage which the Bank then relieves. Because the Bank is the final provider of liquidity to the system, it can choose the interest rate at which it will provide funds each day.

Rather than deal directly with every individual bank, the Bank uses the discount houses as an intermediary. These are highly-specialized dealers who hold large stocks of commercial bills and with whom the major banks place their surplus cash. The discount houses have borrowing facilities at the Bank. The Bank may provide cash either by purchasing securities from the houses, or by lending to them direct. The rates at which the Bank deals with the discount houses are quickly passed on through the financial system, influencing interest rates for the whole economy. When the Bank changes its dealing rate, the commercial banks promptly change their own base rates from which deposit and lending rates are calculated.

The Exchange Rate

Interest rates affect domestic monetary conditions and thus borrowing, consumer demand, investment, output and ultimately prices. They can also have an effect on the value of sterling in terms of foreign currencies. Other things being equal, higher interest rates will tend to attract foreign funds into sterling, and thus increase the sterling exchange rate against other currencies.

The Bank can try to influence the exchange rate using the country's gold and foreign exchange reserves. Management of the reserves is carried out by the Bank on behalf of the Treasury. The reserves are held in a government account called the Exchange Equalization Account, which was set up in the 1930s after Britain left the gold standard: its purpose was and remains to check undue fluctuations in the external value of sterling. This process, known as intervention, involves the Bank buying sterling in exchange for foreign currencies when it wants to curb a fall in sterling - or alternatively selling sterling if it wants to curb a rise. These operations cannot exactly determine the course of sterling in the markets: there are many other influences, and commercial dealers can exert very substantial upward or downward pressure on a currency which official intervention on its own may have difficultly reversing.

As a member of the ERM from 8 October 1990, the UK was obliged to keep sterling within agreed bands relative to other European currencies. The UK's membership of the ERM was suspended on 16 September 1992, since when sterling has been allowed to float freely against other currencies.

Other Policy Instruments

Short-term interest rates and foreign exchange market intervention are the principal instruments of UK monetary policy. Other techniques have been used in the past. In the early 1980s, for example, the Bank sold more government debt than was necessary to fund the government's borrowing requirement, in order to reduce the growth of the broad money supply. This policy of overfunding was abandoned in 1985. Other techniques, now abandoned, have included the imposition of quantitative ceilings on banks' lending (abolished in 1971), requirements on banks to place special deposits with the Bank of England according to how fast their deposits were growing (ended in 1980), and guidance on bank lending, aimed at discouraging loans to consumers. In practice, only market-based instruments have been found to be effective, and as markets have become increasingly open - particularly since the abolition of exchange controls in 1979 - direct methods of monetary management are increasingly unlikely to work.