The Times is running regular briefings to coincide with Target Two Point Zero, the Bank of England competition for sixth-formers run in conjunction with the newspaper. The contest challenges students to play the role of the Bank’s Monetary Policy Committee (MPC) and recommend the best level for interest rates. This week: the role of market interest rates.

What do we mean by market interest rates?

While the Bank of England sets the short-term official Bank, or base, rate by announcing the minimum cost at which it prepared to loan funds to commercial banks overnight, it is left to financial markets to determine other interest rates for borrowing by households and companies spanning periods from days to decades.

The official Bank rate is a crucial factor in determining the level of these market rates, and it is substantially through this influence that the MPC’s power to guide the economy comes. However, other forces such as expectations of the economic outlook, inflation prospects, and demand for money also affect the level of market rates.

Are there different sorts of market rates?

There are two key sorts of market interest rates that play a critical role. Money market, or interbank rates, which are usually quickly affected by changes in Bank rate, determine the cost of loans made by one commercial bank to another. The rates can cover lending over a range of periods, from overnight to several months.

Long-term interest rates are also a powerful influence on the economy, driving the price of companies’ funding for investment, or the cost of a mortgage.

Why are market rates in the news just now?

Interbank rates are grabbing headlines because of a “credit squeeze” in money markets. Commercial banks have been hoarding funds because of fears of losses on investments in bonds that are backed by US mortgages after a slump in America’s housing market.

Along with pressures to finalise their year-end accounts, this has made banks reluctant to lend to each other.

The shortage of funds has driven to record levels the cost of borrowing in interbank markets over periods as short as a day and as long as three months.

Interbank loan rates are measured by “Libor” – the London Interbank Offered Rate, calculated by the British Bankers’ Association. These cover lending in sterling, the euro or dollars. So, for example, three-month sterling Libor rates have recently been at nine-year highs, hitting levels as high as 6.9 per cent. Normally the gap, or spread, between Libor rates and Bank rate (now 5.5 per cent) is much smaller.

Why does this matter?

The rise in interbank rates signals that the MPC is exerting less influence than usual on the cost of borrowing across the economy because of the strained financial conditions that prevail. This could be important as high interbank rates may be passed on in turn to companies and households that want to borrow, slowing the economy in a way that the MPC did not intend in its policy decisions.

What can be done ? Last week, the Bank of England joined other central banks around the world in announcing it would inject, through special auctions, extra funds into the market for lending between commercial banks. This is intended to boost confidence, as well as directly providing more money, or liquidity, to the system, so bringing down Libor rates. So far, however, the action has had only very limited success.

The next briefing is on January 14. Read past briefings here

More on the contest: bankofengland. co.uk/education/targettwopointzero

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