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SUB-PRIME, INTEREST RATES SPREADS AND THE IMPACT ON UK MONETARY
POLICY
The ‘sub-prime’ crisis increased Libor – the benchmark that influences the interest rate
at which the private sector, both corporate and personal, can borrow – by up to 60
basis points, according to research by Christopher Martin and Costas Milas,
presented at the Royal Economic Society’s 2009 annual conference at the University of
Surrey.
This led to an unexpectedly widening differential between medium-term interest rates
and the short-term base rate set by monetary policy-makers. In response, base rates
fell further and quicker than would otherwise have happened as policy-makers sought
to offset some of the contractionary effects of the sub-prime crisis.
The sub-prime crisis, which led to major turbulence in global financial markets
beginning in mid-2007, has posed major challenges for monetary policy-makers. Most
prominence has been given to the attempts by policy-makers to avoid systemic failures
in financial institutions by means of liquidity injections and proposed regulatory reforms.
But the crisis also posed new problems for policy-makers in setting interest rates to
steer the economy towards stable inflation and output levels. One of the main
symptoms of the crisis has been the widening differential between medium-term
interest rates such as the three-month Libor rate and the short-term base rate set by
policy-makers.
This differential is important since aggregate demand is more responsive to the Libor
rate than to the base rate as it is the benchmark interest rate that influences the interest
rate at which the private sector, both corporate and personal, can borrow.
A changing relationship between the base rate and Libor suggests that a given base
rate implies a different level of aggregate demand and hence different levels of inflation
and output. This adds an extra layer of complexity to the problems facing policy-makers
both in terms of setting monetary policy as well as communicating their policy decisions
to the public.
The latter problem became most evident during the November 2008 Inflation Report
press briefing when Bank of England governor Mervyn King and his Monetary Policy
Committee colleagues were accused of being ‘caught with their pants down’ as the
financial crisis switched to a recession.
This research analyse the effects of this changing relationship on the behaviour of
monetary policy-makers in the UK. The study identifies risk and liquidity factors as
being central to the changing relationship between Libor and the base rate. It finds that
the increase in the differential since mid-2007 is largely driven by increases in
unsecured lending risk.
This evidence therefore further supports the argument that the sub-prime crisis was
largely the result of the unwillingness of banks to enter the interbank market because of
uncertainty of the value of assets on offer and, at times, because of fears of the
solvency of their counterparties.
The researchers calculate that the crisis increased Libor by up to 60 basis points. In
response, base rates fell further and quicker than would otherwise have happened as
policy-makers sought to offset some of the contractionary effects of the sub-prime
crisis.
ENDS
‘The Sub-prime Crisis and UK Monetary Policy’
Christopher Martin
Department Economics and International Development
Bath University
01225 384178
Email: [email protected]
Costas Milas
Department of Economics
Keele University
01782 733090
Email: [email protected]