Markets - Money markets

Further work - The behaviour of long-term interest rates

Short-term v long-term rates

Though a change in the official rate unambiguously moves other short-term rates in the same direction (even if some are slow to adjust), the impact on longer-term interest rates can go either way. This is because long-term interest rates are influenced by an average of current and expected future short-term rates, so the outcome depends upon the direction and extent of the impact of the official rate change on expectations of the future path of interest rates.

A rise in the official interest rate could, for example, generate an expectation of lower future interest rates, in which case long-term rates might fall in response to an official rate rise. The actual effect on long-term rates of an official rate change will partly depend on the impact of the policy change on inflation expectations.

The effect of long-term interest rates on asset prices

The price of bonds is inversely related to the long-term interest rate, so a rise in long-term interest rates lowers bond prices, and vice-versa for a fall in long rates. If other things are equal (especially inflation expectations), higher interest rates also lower other securities prices, such as equities (shares). This is because expected returns are discounted by a larger factor, so the present value of any given future income stream falls.