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, the Bank 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 daily basis: to smooth out the imbalances which arise. When more money flows from the banks to the government or 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 thus, on a day-to-day basis, 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.