In Britain, the Bank of England is responsible for the
implementation of monetary policy. The Bank’s Monetary Policy Committee meets
on a monthly basis in order to review a key instrument of monetary policy, the
base rate. This figure indicates the rate at which the BoE is willing to lend
to financial institutions. Despite meeting regularly the MPC have held the interest
rate stable, at 0.5%, since the second quarter of 2009. The BoE’s website
states that this base rate“affects the whole range of interest rates set by
commercial banks, building societies and other institutions for their own
savers and borrowers.”Therefore, it is through this rate that the BoE attempts
to influence expenditure within the economy and thus, in their eyes, it is
central in the transmission of monetary policy.
But how important is this rate for you?
Gaspar and Pérez Quirós, 2004, argue that the interbank
market in fact holds“the first step in the monetary transmission mechanism.” As
the LIBOR rate reflects the true cost of borrowing for banks, they often pin
their interest rates, for both corporate and personal loans, to the LIBOR. This
is in particular the case for short term loans; however, many mortgages are
also linked to the LIBOR. Therefore, it would appear that it has a great effect
on expenditure in the economy. Interestingly the U.S. Commodities Futures
Trading Commission claims that in excess of $800 trillion worth of loans are
fixed to the LIBOR. This, The Economist notes, is ten times the world economy!
The New York Times stated that 45% of prime mortgages, in the U.S., are
affected by it and a staggering 80% of subprime mortgages.
How is the LIBOR different?
As the interbank market involves unsecured lending, the
base rate incurs a risk premium (Christensen, Lopez, Rudebusch, 2009). Thus,
during riskier economic periods, interbank rates, such as the LIBOR, are more
volatile and see a greater divergence from the base rate. This can be clearly
seen from the graph below. So, if your loan is linked to the LIBOR rather than
the base rate, tough economic times will become even tougher.
