What are long-term rates and why care about them?
While the Bank sets short-term official “base” rates, it is left to the financial markets to determine other interest rates for borrowing for periods ranging from days to decades. The level of such rates is determined principally in the bond market and is driven by trading in government securities - in Britain, gilt-edged stocks.
These rates affect the cost of capital for companies and financial institutions, and in turn for households, and thus affect investment and consumer spending. Changes in the Bank’s official rate generally feed through to longer-term rates but to a varying degree and with uncertain timing.
What attention is paid to market interest rates by the MPC and how are they gauged?
Policymakers pay close attention to market rates because these are a key element in monetary and financial conditions.
Advertisement
The Bank tracks bond markets and the shape of what is called the “yield curve”. This curve is given by plotting the interest rate set in the market (the yield) for bonds issued for different time durations.
Typically, if lenders tie up their money for a longer period, they require a higher yield. Yields move inversely to bond prices, so that as the price rises the yield falls, and vice versa.
There has been much talk recently of an “inverted yield curve” in the United States. What is this, and does it matter?
The yield curve inverts when, unusually, interest rates for shorter periods, including official short-rates, are higher than those for longer periods. This is often seen as a warning of recession or at least of growth slowing. Low longer-term rates may anticipate weakening economic conditions in future.
The yield curves in both Britain and in the United States are inverted at present.
Advertisement
Is this signalling worse economic times ahead?
Nobody knows for sure. In the US the yield curve has inverted before every postwar American recession and has sent only one false signal over this time. With the American economy slowing thanks to its housing downturn, some do fear a recession. Things may be different now. The recent change in the curve may, for instance, reflect hopes of inflation falling markedly.
Are there other explanations for the trend in Britain and the US?
A year ago Mervyn King, the Bank’s Governor, discussed the puzzle over why long-term interest rates were unusually low in Britain. At that time, UK long-term rates on government bonds were at 50-year lows, although they have risen since. He set out two explanations.
One was that high rates of saving globally, and low levels of investment, could have meant a glut of capital for those wishing to borrow, depressing rates. The second was that previous, very low short-term rates have led to rapid growth in the amount of money circulating, leading investors to seek higher returns wherever they can, pushing up prices for many assets, including bonds.
Advertisement
Higher bond prices then pushed yields lower.
Could this be dangerous?
Either of these circumstances could create economic turbulence if they unwind and longterm rates rise sharply.
www.thetimes.com/targettwopointzero
www.bankofengland.co.uk/education/targettwopointzero