5.3 Monetary policy and the money markets

convergence in recent years. Essentially, there are three possible ways of making reserves

available and setting their price. These are:

l	lending via the ‘discount window’;
l	open market operations;
l	repurchase agreements.

‘Discount window’ lending refers to the situation where the central bank lends

directly to banks. The loan is usually secured against some collateral. (In the days

before parallel markets this collateral was always bills. Since the loan was usually less

than the value of the collateral, it was ‘at a discount’.) In most systems, discount

window borrowing is limited to specied institutions. In the US, for example, it was

restricted to member banks of the Federal Reserve System until 1978. In the UK,

such loans were available only to the subset of banks known as discount houses

until 1998 (though discount window lending largely ceased in the UK in 1981).

The loans are for short periods, usually a matter of days. The rate which the central

bank currently charges on such loans is widely advertised. Banks know the cost of

the loan in advance.

In recent years, there has been a convergence of central banking operating tech-

niques away from discount window lending towards more ‘market-based’ methods

of intervention. Assistance via the discount window requires the authorities to make

a lot of decisions themselves. These decisions might or might not be appropriate,

in the light of market conditions. For example, discount window lending requires

the authorities to decide from time to time on the rate which they charge and to

‘post’ this, i.e. make it known to everyone, continuously. In making this decision,

the central bank will make an assessment of the likely rate of expansion of money

and credit and the likely degree of shortage of reserves for the foreseeable future.

However, it may be wrong in its estimate. It might, for example, overestimate the likely

shortage. It then sets the discount rate ‘too low’. Having set the rate, it is obliged to

supply reserves at that rate to all eligible borrowers. If for commercial banks the rate

is ‘low’ relative to what they can charge for loans, they are likely to borrow a great

deal of reserves and expand their lending rapidly. There is a monetary expansion which

the central bank did not intend. Given this rapid expansion, the central bank may

then decide to raise the discount rate, say by 50 basis points (bps). But in doing this,

they may underestimate the degree of liquidity in the market. If there is no shortage

of reserves, banks will not need to borrow from the discount window and loan rates

will not rise. Establishing the appropriate discount rate is a technical problem. In

some countries there has been a political problem too.

Because central banks have to post or announce the rate for discount window

borrowing, it is obvious that the central bank is setting interest rates. In some

countries, where the central bank is closely linked to government, this looks like

government setting of interest rates. During the 1980s there was a general move-

ment in economic policy making towards a general belief that ‘markets know best’.

In a period when markets were generally being liberalised, such explicit intervention

in money market interest rates looked odd. For all these reasons, central banks moved

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Chapter 5 • The money markets

in the 1980s toward operating techniques which gave a larger role to market forces

(or at least appeared to do so). Such techniques include open market operations and

repurchase agreements. We shall explain both of these by looking at the develop-

ment of the Bank of England’s money market operations in recent years. The years

from 1981 to 1996 mark the high point of open market operations, while the move

to repurchase agreements began in 1997.

On taking ofce in 1979, the Conservative government launched a major review

of the recent operation of UK monetary policy and of possible alternatives. In the

light of the subsequent Green Paper (1980), the Bank of England rejected the pos-

sibility of moving towards monetary base control (for all the reasons we have seen

above and in Box 3.5) and reafrmed its commitment to interest rate setting. The

operating techniques were, however, changed. The Bank abandoned its previous prac-

tice of providing liquidity to the banking system by lending to the discount houses

at a preannounced rate of interest (known at the time as Minimum Lending Rate).

Instead, it set out to make more use of market forces. This involved making a twice

daily forecast of the money markets’ liquidity position. This involved taking account

of the inuences listed above in Box 5.3. In the light of the resulting forecast, it

then stated that it would be willing to provide assistance (in the case of a shortage)

by making outright purchases of treasury and eligible commercial bills. The maturity

of the bills was restricted to the very short end of the maturity spectrum (less than

fourteen days), and transactions in bills were conned to the Bank and the dis-

count houses.

Open market operations:The purchase (or sale) of any asset in the open market.

Crucially, there was no announcement of a purchase price for these bills and thus

the discount houses (and money markets) could not know in advance what rate

of discount the Bank was going to impose. The discount houses had to set their own

offer price and the argument was that this would tell the Bank something about the

degree of liquidity shortage (low offer prices indicating a major shortage, for example).

In the circumstances of general liquidity shortage, the Bank would be the monopoly

buyerof bills and could set its own price. If it wished to raise money market rates,

it would reject the bills offered by the discount market and invite a resubmission

at lower prices. (Again, the new prices had to be set by the discount houses.) In

practice, the rst submission of bills for sale would usually be made at prices closely

equivalent to the existing discount rate. If the Bank wanted interest rates to remain

unchanged, it simply bought all the bills at prices reecting the going discount

rate (making the supply of liquidity perfectly elastic at the going rate of interest).

Whatever the Bank’s response, notice that there was never any doubt that liquidity

would be forthcoming. Supplied with liquid funds, the discount houses could then

meet any demand from the rest of the banking system for repayment of money at

call. The rest of the system would get the additional reserves.

Referring to post-1981 operating techniques as ‘open market operations’, however,

is exaggerating slightly. An open market is one to which everyone has access. As we

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