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:

Costas Milas

Department of Economics

Keele University

01782 733090

Email: