Markets - Money markets

Explanation

It all sounds very easy in principle. You just say 'the interest rate is ....%' and then sit back and wait another month to decide interest rates again. Wrong! Once the MPC has set an official rate for each month, the Bank of England has to actively intervene in the money markets every day to ensure that the official rate that has been set is also the equilibrium rate in the market.

They do this as a two-stage process. First, they create a 'shortage' in the market. In other words they make sure that the banks and other financial institutions do not actually have enough liquidity to meet their commitments each day. This sounds crazy to keep them short, but if they are short they have to get their cash from somewhere. That somewhere is the Bank of England.

This leads on to the second stage. When the banks and other financial institutions come to the Bank of England needing cash, the Bank offers them what are called 'repos'. A repo is a 'sale and repurchase agreement'. In other words the Bank offers to buy various assets (usually gilt-edged securities and Treasury Bills) back from the institution concerned in exchange for cash. In the meantime, the banks have to pay the official interest rate on the cash they have borrowed. A fortnight later they have to return the cash to the Bank of England and they get their gilts and Treasury Bills back again. This is where the expression 'sale and repurchase' agreement comes in. The institutions concerned sold their gilts, etc. to the Bank of England (in exchange for cash) and then bought them back a fortnight later.

One way to think of this whole process is as a game of musical chairs where the Bank removes a chair from the market each day. They then give the chair back during the day, but on the terms they want to! So, the point of this is that all the borrowing, which the financial institutions had to do, was at the official rate. That helps to maintain the official rate in the markets.

For more details on this, why not have a look at the theory section.