A century and three‐quarters of Bank Rate and long‐term interest rates in the United Kingdom

• Published date: 01 March 2017
• Date: 01 March 2017
• Author: Hakan Berument,Richard Froyen,Ezequiel Cabezon
• DOI: http://doi.org/10.1111/infi.12101

DOI 10.1111/infi.12101

ARTICLE

A century and three-quarters of Bank Rate and

long-term interest rates in the United Kingdom

Hakan Berument

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Ezequiel Cabezon

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Richard Froyen

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1

Bilkent University, Ankara, Turkey

2

International Monetary Fund,

Washington, District of Columbia

3

University of North Carolina, Chapel

Hill, North Carolina

Correspondence

Richard Froyen, University of North

Carolina, Chapel Hill, North Carolina.

Email: froyen@email.unc.edu

Abstract

Over the years from 1844 to 2013, the United Kingdom had

several distinct monetary policy regimes. This paper

examines the relationship between the Bank of England

policy rate and UK long-term rates in each regime. Our

starting point is R. G. Hawtrey’sA century of Bank Rate,

which focused mainly on the classical Gold Standard. We

also examine the Interwar years, post-Second World War

years of policy by discretion and the recent regime of

inflation targeting. We find that policy regimes that firmly

anchor inflationary expectations result in long-run interest

rates becoming less responsive to changes in monetary

policy rates. This suggests a conflict between a regime that

anchors inflationary expectations and one that allows a

central bank to have significant effects on long-term rates

via a short-term policy rate.

KEYWORDS

inflation anchors, long-term interest rate, monetary policy

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INTRODUCTION

This paper examines the relationship in the United Kingdom between Bank Rate (or another monetary

policy rate) and the long-term interest rate over monetary policy regimes going back to 1844. We also

consider the implications of this relationship for the channels through which monetary policy actions

are transmitted to the rest of the economy. The time frame enables us to examine these questions for the

classical Gold Standard (1844–1913), a period of instability during the interwar years (1919–1939),

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© 2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/infi International Finance. 2017;20:26–47.

years of policy by discretion, with and without a fixed exchange rate system (1952–1992), and an

inflation targeting regime (1992–2013).

Recent literature examine s the role of the policy regime in dete rmining the sensitivity of lon g-

term rates to changes in polic y rates and other nominal dist urbances. Inflation tar geting by

anchoring long-term inflati onary expectations is argued to produce an environment where lo ng-term

interest rates ‘jump around a b it less and businesses and in vestors might find it easie r to draw up

long-term contracts’.

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Bernanke (2004, p. 166) ar gued that ‘the apparently hi gh sensitivity of long-

term nominal interest rates to Fed actions suggests some unc ertainty about the Fed’s long-run

inflation target’.

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The title of this paper referenc es Hawtrey’s(1938),A century of Bank Rate. Hawtrey’sworkand

controversy with Keynes brin g us to the nexus between the polic y regime and the transmissio n

mechanism for monetary po licy. Hawtrey conducted ‘mo st laborious ad hoc statistica l

investigations’(Roberts on, 1937) of Bank of England policy from 18 44 to the mid-1930s.

Hawtrey studied the relation ship between Bank Rate and the Cons ol rate with implications for

monetary policy. To Hawtrey the short rate mattered, th e rate on Consols being only slightly

influenced by Bank Rate. As Rob ertson (1937) put it, ‘Mr. Hawtr ey expands and illustrates th e

principle that the repercuss ions on the long rate of a change in the short rate which is expected to be

reversed before long is likely to be relati vely small’.

Keynes (1930) took the oppos ite view: it was the long-term r ate that was important via its ef fect

on fixed investment. While granting that ‘it may seem illogical that the r ate of interest fixed for

three months should have any no ticeable effect on terms aske d for loans of twenty years or mor e’,

he concludes that ‘the influenc e of the short-term rate of inter est on the long-term rate is much

greater than anyone who argued on the above lines would have expected’(p. 316).

Hawtrey and Keynes focuse d on different policy regime s. Hawtrey’smainfocuswasthe

classical Gold Standard. Ke ynes’s focus was on the post-Wor ld War I years when a Gold Standard

was not in effect or was precario us. Their research anticipa tes the recent literature on th e

relationship between the mone tary regime and sensitivit y of long-term rates to short-te rm policy

rates.

For the transmission mechanism, we then have the Hawtrey Effect via the short rate directly

and the Keynes Effect via the long-term rate. In New Keynesian models that are widely used for

policy analysis today, which is it? In the earlier generation of Keynesian models, the interest

rate was the long-term rate (Hicks, 1946, p. 148; 1967). From Woodford (2011, p. 727) we have

that in the New Keynesian model the interest rate is the short-term rate. In forward-looking

versions of the model, however, the ‘expected future path of short-term interest rates’also

matters (p. 16). The interest rate channels in the New Keynesian model require attention at a

later point.

Moreover, Woodford’s (2003) neo-Wicksellian model revives the concept of the natural rate

of interest. This concept was an element in Hawtrey’s and Keynes’s analysis up through the

1920s. Keynes jettisoned the concept in The general theory, writing that he was ‘no longer of

the opinion that the concept of a “natural”rate of interest has anything very useful of

significance to contribute’(1936, p. 243). This issue receives attention at a later point.

Going forward we focus on the relation ship between the Bank of England po licy rate and the

long-term rate of interest in the Unit ed Kingdom over policy regimes dating back to 1844. Section 2

provides background and summa ry statistics. Section 3 des cribes our statistical proc edures.

Sections 4–7 examine four disti nct policy regimes. Section 8 c oncludes.

BERUMENT ET AL.

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